In my last blog I made a very simple point, namely that the low or negative real interest rates that prevail currently across the developed world mean that returns from safe haven bonds will almost certainly be very poor in coming years and decades.
This makes them high risk, though you’ll lose money gradually i.e. with low volatility. You may however have to wait a little while longer for the much-anticipated bond bear market to begin. But then patience has always been a critical factor in investing.
This quarter, I look at equities and consider the risk associated with them, concluding that equities are in fact less risky than is generally perceived.
First things first: how do I define risk?
In the case of bonds, I defined risk as the scope for permanent loss of real capital rather than short-term price volatility. The scope for permanent loss of real capital could most simply be measured by looking at prevailing real yields.
If real yields are negative, then you have a very good chance of losing real capital by buying and holding to maturity (realised inflation has to be much lower than expected inflation for returns to be positive).
But you can also assess the scope for permanent loss of capital – for both bonds and equities – by considering the volatility of long-term real returns (the volatility of short term returns can be seen as a measure of the scope for temporary rather than permanent loss of capital – what goes down one month often goes up again the next).
So, let’s say I have an investment time horizon of 30 years – if I’m saving for retirement this would be appropriate.
Now, by definition, if I lose money over that time frame, the loss is permanent – I have run out of time. So, by calculating the volatility of 30 year real returns from bonds or equities, we get a measure of the scope for permanent loss of real capital (or at best the scope for returns to be well below expected returns).
Source: Credit Suisse
In the US, the standard deviation of rolling 30-year real returns is much higher for bonds than for equities (the distance between the dotted lines).
Furthermore, with bonds, you would have lost money in real terms over 30 year periods around 20 per cent of the time. With equities, the worst 30-year real return was 1 per cent per annum (from 1902 to 1932). Which all means in my book that bonds are riskier than equities but also that equities are less risky than is generally perceived.
How else can the riskiness of equities be considered?
In 1981, Yale professor Robert Shiller wrote a paper that was published in The American Economic Review titled, ‘Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?’.
The paper concluded that “measures of stock price volatility over the past century appear to be far too high – five to thirteen times too high – to be attributed to new information about future real dividends if uncertainty about future dividends is measured by the sample standard deviations of real dividends around their long-run exponential growth path.” In short, ‘yes’.
Source: Robert Shiller
Shiller noted simply that the equity index price level should be equal to the present value of future dividends and that this present value could be influenced by two things and two things only: the growth rate of future dividends and the discount rate used to discount those dividends.
His conclusion, as noted in the previous paragraph, was based on the assumption that expectations of big changes in future dividends implied by actual stock price movements were irrational because such changes had never happened in the past.
Shiller writes, “Perhaps the market was rightfully fearful of much larger movements than actually materialised. One is led to doubt this, if after a century of observations nothing happened which could remotely justify the stock price movements.”
As for large movements in the discount rate that would have justified the stock price volatility, Shiller noted that, “Since expected real interest rates are not directly observed, such a theory cannot be evaluated statistically unless some other indicator of real rates is found. I have shown, however, that the movements in expected real interest rates that would justify the variability in stock prices are very large - much larger than the movements in nominal interest rates over the sample period.”
The implication of Shiller’s conclusion is that if markets overreact there exists a profit opportunity.
He writes, “…if real stock prices are “too volatile” as it is defined here, then there may well be a sort of real profit opportunity.”
In other words, buying and holding equities may already be less risky than is generally perceived but by taking advantage of excessive short term volatility you can reduce risk – as defined by the scope for permanent loss of real capital - even further.
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.