September 27, 2011
There has been a massive switch from equities to bonds since 2008 as investors have attempted to de-risk their portfolios. But does this shift make sense?
It is true that bonds are less volatile than equities, but at current yields they also offer less return than normal. We expect sovereign bond returns over the next decade to be closer to their current yield of around 3%, rather than their more usual yield in the region of 5%.
And, certainly relative to sovereign bonds, equities look unusually attractive just now. The average price-to-book ratio of 1.8x compares with a more normal 2.5x, while global corporate profitability continues to improve. Moreover, dividend yields at about 3% are also attractive compared to the current yield on sovereign bonds.
This combination of strong income and valuation support boosts our central case for compound annualised equity returns of 9% over the next decade, compared with a more usual 8% or so.
In a normal decade, bonds have a one-in-three chance of beating stocks, but we now estimate an almost 90% chance that stock returns will exceed sovereign bond returns over the next ten years.
Investors who have de-risked by buying bonds have reduced the volatility of their portfolios. But lower short-term risk may come at the expense of lower longer-term returns. There is a possibility that, in seeking to avoid risk in the near-term, investors have guaranteed they will not meet their objectives in the long term. In which case, today’s de-risking may prove over time to have been reckless.
Many investors would be better served by setting out a “glide path” that prompts them to de-risk their portfolios as they approach their investment goals, perhaps by swapping equities for immunizing bonds or swaps. They would still be exposed to tail events, but investors can help protect themselves against such risks by using dynamic asset allocation, income guarantees and other hedging strategies.