Sometimes the risky option is the only safe option, and so it is today. Prices of all financial assets are extremely high by historical standards, helped in this respect by the floods of cash released into markets by central bankers and quantitative easing. And geopolitical tensions are back to their normal levels as America learns the cost of being the world’s policeman and becomes more isolationist.
Back to the future
Readers of 19th century novels will know that the key requirement of a satisfactory bridegroom was a certain yet safe income, and this came from the ownership of first-world government bonds. This simple world came to an end with the 20th century; rising prices associated with financing wars, and increased government manipulation of the economy to bring about desirable social ends – such as the alleviation of poverty or greater economic growth – made fixed income investments dangerous loss makers.
But, bridegroom or pensioner, the need for income never went away. By the 1950s, a diversified portfolio of shares was considered to be the best way of providing an income that would offset the problem of inflation. For those lacking a stockbroker, or fearful of stock markets, mutual funds [unit trusts] sold by insurance salesforces offered apparently easy ways of making money in this inflationary but fast-growing world of economic opportunity.
This cult of the equity ensured that, up to 2008 and the banking collapse, equities yielded less than bonds, despite their greater volatility and real risk of dividend cuts or even bankruptcy. However it was also in the 1980s that Paul Volcker, then head of the US Federal Reserve [the US central bank], persuaded investors that he was determined to drive inflation out of the system.
Such is the irony of financial markets that, thanks to Mr Volcker, bond investors have actually done better than most equity investors over many of the last 30 years. It is this history, plus quantitative easing, that has pushed bond prices into bubble territory.
Plus ça change...
Those financial certainties have gone away. The efficient market hypothesis has proved a chimera, emerging markets a fast-fading dream of simple riches, and now there are doubts about the certainty of regular, annual economic growth, the foundation of corporate profits and dividends. So it is no surprise that GMO, the well-respected Boston-based asset manager, reckons that US returns from cash, bonds and shares over the next seven years will be lower than inflation.
So far the 21st century has returned actual losses to UK equity investors. Savaged by the bear markets in 2001/2 and 2008/9, annualised equity total returns from the start of 2000 to 2014 have only been 1.2 per cent compared with 2.5 per cent on bonds, and both beaten by inflation of 2.7 per cent, according to the Credit Suisse Global Investment Returns Sourcebook 2014.
It has been worse for private investors; research shows that they enter markets late in the up-cycle, and disinvest too late in the downswing, so worsening the returns shown above.
Private investors have no chance of matching the reaction times of professionals, but they have other advantages. The first is time, and the second the ability to make their own decisions without the need to please superiors. Sadly, most ignore these but, properly understood, they can enable investors to outperform markets and many professionals.