MANPREET GILL: Diversified allocation trumps equities-only approach over long term

MANPREET GILL: Diversified allocation trumps equities-only approach over long term

2021-10-21 12:30:00 AM

MANPREET GILL: Diversified allocation trumps equities-only approach over long term

Among the numerous pitfalls is the danger of investors failing to hold their nerve at times of market distress

Manpreet GillPicture: 123RF/POP NUKOONRATA client recently asked us an interesting question about long-term investing: if one wishes to pass on an inheritance to the next generation, should it be fully invested in equities alone? At face value, there is a temptation to say yes. Equities, as is often repeated, have historically outperformed other asset classes “in the long term” and, so the argument goes, the inevitable volatility along the way should not matter over such a long time horizon. However, a few things could go wrong with such an approach.

While the appropriate allocation will always differ from one situation to another, in most cases a somewhat more diversified allocation could end up being a more prudent approach.Many studies show equities outperformed bonds and cash over long time horizons in the post-World War 2 period. One of the most famous studies in this space, Jeremy Siegel’s

Stocks for the Long Run, uses considerable US market data to show that, over a sufficiently long period, equities have done a better job of delivering inflation-beating returns than (government) bonds, gold or cash.While there has been much debate over whether investments made at current valuation points will deliver much lower returns than we are used to historically, the relative ranking between asset classes is still likely to hold. headtopics.com

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Our long-term (multiyear) expected returns, put together in partnership with Mercer Consulting in late 2020, show that global equities are expected to deliver annualised returns in the mid-single digits. While this is lower than we are used to historically, it is still higher than the less than 1% annualised returns expected from global bonds and cash, and potentially negative returns from gold. Such a future would look very much like the past, albeit with somewhat lower annualised returns across the board. Does that mean we should allocate to equities alone for the long run?

Possibly one of the biggest risks is that an all-equity strategy would make us more susceptible to making a behavioural mistake. To provide just one example, the global equity index fell almost 60% from its October 2007 peak to its March 2009 trough.Do nothing

Looking back at history, we now know that the correct action for a buy-and-hold investor with a multidecade horizon would have been to do nothing. However, amid the screaming headlines at the time, would we honestly have been able to avoid making the mistake of selling some, or all, of our holdings in panic? In this bull market, it is easy to say we would not. Yet there are countless anecdotes of investors who failed to hold their nerve at that time: selling close to the market low and exacerbating the situation by not reinvesting to take advantage of the subsequent equity market rebound.

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Most diversified investment allocations would have fallen over that period as well. However, a diversified allocation across equities, bonds, gold and cash would have fallen by much less than 60% and gains in asset classes such as bonds and gold would have offered opportunities to take profit and rebalance into equities as they fell. This would not only have reduced the chances of making an investment error, but possibly even created a situation in which rebalancing would have led one to add to equities at an opportune time. headtopics.com

We should also be wary of the following risks of focusing on equities alone:Many studies highlighting the historical outperformance of equities over long horizons focus on equity indices. While the conclusions of the study would apply if implemented through mainstream equity indices, implementation via anything more specific — sectors or specific stocks, for example — would thus introduce additional layers of complexity that could lead to a very different outcome, including the risk of permanent loss. For example, of the “Nifty 50” stocks popular in the 1970s in the US, many are no longer even publicly traded.

Most available research uses US data, sometimes with a disproportionate focus on post-World War 2 history. It is plausible that the experience outside the US may not be exactly the same. Other studies have also argued that pre-World War 2 data shows performance between equities and bonds was much more evenly matched. While much of this may seem like ancient history, when considering investment allocations targeted at multidecade horizons, it is fair to question whether the next 50 years will indeed look like the past 50.

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A broad-sweep characterisation of equities and bonds can hide many opportunities a level or two down from these large categories. For example, our long-term expected returns show that asset classes such as emerging-market local currency bonds or listed infrastructure could offer long-term returns competitive with global equities, while offering diversification benefits.

A lot can happen over a long time horizon, and while history is often a useful guide, it is far from guaranteed that future decades in financial markets will look exactly like past ones. For investors, while a large allocation to equities makes sense over such long time horizons, we believe a reasonable amount of diversification can help mitigate the journey’s risks and maximise the investment returns. headtopics.com

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