An important consideration when determining your optimal asset allocation mix is to consider the potential risks and rewards to be realised from various asset classes.
The events of 2008 clearly remind us of the risks involved with investing in volatile asset classes such as shares but what should we expect to achieve from these investments?
Each year Credit Suisse publishes their Global Investment Returns Yearbook which looks at historical returns for major markets. The 2011 yearbook which includes data up to the end of 2010 provides some very useful insights.
Over the 111 years of data available to the authors,
- Equity returns have beaten inflation, treasury bills (short duration government debt) and bonds in all 19 countries included in the study.
- Australia has been the best performing equity market with a real return of 7.4%.
- The equity risk premium in Australia has been 6.7% over risk-free treasury bills.
- The equity risk premium in Australia has been 5.9% over bonds.
- The volatility experienced in Australian shares has been slightly higher than the global average.
- A globally diversified portfolio of equities has provided a real return of 4.5% over Treasury bills and 3.8% over bonds
On top of this pure statistical analysis, the authors of the report – Dimson, Marsh, Staunton, Holland & Matthews provide analysis of two key investment issues:
- Whether we are experiencing a bond market bubble and the implications for investors?
- Whether chasing higher yielding share investments provides a better outcome over the long term?
The analysis contained in the report suggests that over the past 30 years, and especially the last 10 years, there have been strong returns from investing in bonds on a par with or better than equity returns across the globe. (Australian shares have out-performed Australian bonds over that period.) Over the long term bonds have provided less returns with less volatility which suggests the returns from the past decade have been abnormal. The authors therefore suggest that the strong performance from bonds should not persist especially within a low interest rate period with higher inflation expectations.
In terms of high yielding shares, the research clearly suggests there is a premium to be earned from investing in this style of shares over the long term as reflected in the long term historical data. Over short time periods higher yielding shares may under-perform so it is not a free lunch.
Conclusions
So what can we take away from these findings?
I believe that the report reconfirms a number of the approaches to investment applied in client portfolios:
- If you can afford a long timeframe for your investments (preferably forever) than share investments do provide a significant premium over inflation, cash and bonds and should form a significant part of a portfolio.
- It has been prudent to have an over-weight exposure to Australian shares being conscious that this may provide a slightly higher level of volatility.
- Bonds have had a great recent performance history but this is unlikely to continue forever. However we should not expect to see huge falls in bond prices especially at the lower maturity, higher quality part of the market.
- Bonds have provided a slight premium over more liquid defensive assets and therefore are a valid use as a part of an asset allocation to reduce volatility but provide a slightly higher return than investing in cash.
- Incorporating a higher yield / value strategy into asset allocations is a valid approach to lift expected returns.
Please take a look at our Building Portfolios page for further details of our approach.
Regards,
Scott
