Here’s a question. From November 1940 to September 1981, the annualised standard deviation of real returns from US long dated bonds was 7.3 per cent. In comparison, the number for equities was 17.6 per cent. Which was riskier?
Well, equities of course! 17.6 per cent volatility is much higher than 7.3 per cent and volatility is risk, right?
Well, over the forty year period, you’d have lost 67 per cent in real terms investing in US long dated bonds. But you’d have lost it gradually, hence the low volatility. To put it crudely, you’d have been the proverbial frog in the pot of water being warmed slowly to boiling point. You wouldn’t have noticed that you were being screwed.
As for equities, they returned 925 per cent over the period in question.
I can’t imagine there are many who would consider losing money slowly preferable to making money less slowly. Surely there must be a better way of measuring risk.
The reason for the poor performance of bonds was simple: inflation.
From 1940 to 1981, the inflation rate in the US rose from 0 per cent to 11 per cent. It didn’t do this in a straight line but in a zig-zag, with the rate falling somewhat in the 1960s before continuing up throughout the 70s towards its final destination in the early 80s.
Nevertheless, the real value of both coupons paid as well as principal were eroded over the period which of course all added up to poor real returns for investors.
Thus the risk of bonds performing poorly for prolonged periods can ostensibly be thought of as inflation risk. Indeed inflation risk is what causes bonds to perform poorly over short periods too.
It is often said that governments have two ways of defaulting: slowly or quickly.
The quick way involves ceasing payment of coupons and principal. The slow way to default is perhaps more insidious: through inflation that causes coupons and principal to fall - not in nominal terms but in real terms.
In other words, inflation risk can be closely related to default (or solvency) risk. Both cause permanent loss of capital.
Indeed, permanent loss of capital is what we should all fear. The problem is that measuring the scope for permanent loss of capital is hard. It involves assessing whether a company, government or individual is going to default or whether inflation is going to rise over a long period.
This requires research skills that many do not have. Much easier to use volatility that can be calculated on the back of a cigarette packet.
The problem is that volatility has little if anything to do with permanent loss of capital. Volatility is a measure of market risk, the risk that you’ll make losses as a result of market movements. And since most downward movements in markets are followed by upward movements, volatility can be thought of as temporary loss of capital not permanent.
This obsession with volatility as risk dates back to 1952. It was in this year that Harry Markowitz wrote his ground-breaking paper Portfolio Selection.
In it, Markowitz set out a framework for constructing portfolios, concluding that the rational investor would want to own the market portfolio (the portfolio made up of all securities in the market). His idea, for which he won the Nobel Prize, was based on the premise that “the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing”.
Later in the paper he writes: “The concepts "yield" and "risk" appear frequently in financial writings. Usually if the term "yield" were replaced by "expected yield" or "expected return," and "risk" by "variance of return," little change of apparent meaning would result.”
From this moment forth, volatility would be seen as something to be avoided, rather than something to embrace.
As Research Associates’ Rob Arnott succinctly put it in his article Institutionalizing Courage: “Temporary losses of value are frequent; at times they can become so frightening that they become permanent—for those that sell.”
This is the nub of the problem. Volatility is generally measured over time periods that should not concern us.
If you need your money in the next couple of years the riskiest thing you should invest in is a 2-year Gilt. If you invest in long-term assets such as equities but worry about short-term volatility, you are liable to make the cardinal error that Arnott cites.
However, if you are minded to hold on tight, perhaps you might also take the next leap of faith: taking advantage of dips by buying. Remember, most people tend to run towards shops and stores displaying “50 per cent off!” signs, not away from them. Perhaps we can learn from them.
If we are going to use volatility as a measure of risk, using periods that matter (or should matter) to us as investors is essential. For most, this means 30 years or more. So, the volatility of annualised rolling 30 year returns from equities has been 1.6 per cent, reflecting equities’ ability to recover from dips. As for bonds, the number is 2.7 per cent, reflecting the multi-decade periods when bond returns have been miserable.
In other words, equities are less risky than bonds. Now there’s a finding!
Peter Elston is chief investment officer at Seneca Investment Management. All the views expressed above are his own and shouldn’t be taken as investment advice.