Diversify, diversify, diversify

The FTSE 100 is the benchmark index for UK equity investing, and it remains the shorthand reference for private client investment.

While we in the UK have an admirable history of equity investment, very few financial advisers these days recommend full equity allocation, even for savers at an early stage in their careers.

It is easy to see why, as investing in an all-equity portfolio, in particular in equities of a single country, carries significant short to medium-term risks. During market downturns, stocks can be penalised irrespective of underlying company fundamentals.

The FTSE 100 index has experienced several major setbacks since its inception in 1984, falling -47.9 per cent after the dot-com bubble and -40.6 per cent after the global financial crisis.

Longer data analysis obtained from the Barclays Equity Gilt Study indicates that there have been six periods since 1899 when the UK equity market took at least five years to return to its pre-bear market levels (1910-18, 1937-45, 1947-53, 1972-78, 2000-07, 2007-13). In the worst two cases, 1910-18 and 1937-45 – periods bookmarked by war – the recovery took nine years.

In the modern-day context, these are unacceptable periods of nil or negative returns for all but guardians of multi-generational wealth.

Despite the frequent references to theory about investing for the long term, these oft-expressed desires are largely unconsummated.

Last month, the Government instituted compulsory occupational pensions, further proliferating investment need and activity. With proliferation comes the quite understandable desire to avoid negative outcomes, an instinct most keenly felt by financial advisers, who face their clients and the regulator.

As a consequence, there is a general incentive to de-fang the equity market. The potential for capital gain or loss in an investment is the definition of risk, and risk is often proxied by measurement of volatility of historical returns. Risk and return are interlinked, where conventionally higher risk is associated with greater probability of higher returns, and vice versa.

The table below shows the real returns (after inflation) of a selection of UK assets over the past 116 years. The FTSE 100 produced a 5 per cent annualised real total return compared to 1.3 per cent for UK gilts over the full period, achieved with almost twice the volatility (20 per cent versus 12 per cent). However, it may not always be the case that one is compensated for taking on more risk.

UK Asset class returns (% a year in real, after inflation, terms)
201510 years20 years50 years116 years
Government bonds-
Corporate bonds-0.51.8
Index-linked bonds-

Source: Barclays Capital Equity Gilt Study

As we can see from table A, while over the long-term equity returns easily outperformed bonds, the risk return trade-off between the two has not been a great one over the more recent 20-year period, where equities underperformed bonds even though their volatility remained much higher (15 per cent versus 8 per cent).