Investors Need to Be Mindful of Hindsight

It’s been a tough time for investors lately with the world’s major sharemarkets struggling to produce any meaningful capital gain over the past five years.

The disappointment, though, goes deeper: since the start of this century the US sharemarket, measured by the S&P 500 Index, has fallen by 13 per cent, and that’s before taking into account the erosion in value caused by inflation over that time.

In contrast to shares, world bonds have performed spectacularly well (up over 100 per cent) since 2000. The yawning gap in returns between bonds and shares doesn’t depend on the starting point being 2000 either; you have to use more than two decades worth of (US) data before you can show that shares have delivered higher returns than bonds.

It’s perhaps not surprising then that investors have shifted some of their funds away from shares and into bonds. According to data from over 40 countries compiled by the Association of US Investment Companies, investors have reduced their allocation to shares from almost 50 per cent at the end of 2006, to 39 per cent by the end of September 2011, and upped their allocation to bonds and money market investments.

In making the shift, of course, they have contributed to the downward pressure on shares prices and helped push up bonds.

There are at least three reasons behind many of world’s savers shifting from shares to bonds over the past five or more years:

The obvious one is that bonds have simply delivered better returns than shares – in hindsight the shift in funds has been a no-brainer. But could bonds turn from being a no-brainer to being a genuinely stupid investment over the next 10 years?

Another compelling reason for the shift to bonds is simply a flight to safety. Bonds traditionally offer much greater security over the capital value of an investor’s funds in exchange for a lower return than is the case for shares. Given the huge uncertainty that has dogged financial markets for much of the past five years it’s small wonder that investors have withdrawn to the relative safety of bonds. As the turmoil in financial markets fades investors may be inclined to take on more risk and nudge their way back into shares.

A third reason for the shift to bonds may be more fundamental. The demographic bulge in the number of people hitting retirement is likely to see a sustained shift to more conservative investment mandates. As this large age cohort retires their focus will be on the security of their capital rather than the returns they can get from that capital. If the financial crisis has taught us anything it is that returns that look too good to be true, too often are. For New Zealanders that message was repeated loudly by the collapse of finance companies that had lured many retired folk to invest in dubious debentures by offering unsustainably high interest rates.

The first two reasons above rely heavily on hindsight, something that investors find very difficult to shrug off. Investors are told time and again that over the long run shares will produce higher returns than bonds; the basic rationale being that shares carry more risk and therefore investors seek higher returns.

Well, as we’ve seen that has not been the case for the past decade or more, which raises the question: how long is the long term? For a 65-year-old, 10 years may be all the time he’s got left, whereas a 25-year-old can afford to hang on for long-term relative returns to prevail – shares outperforming bonds.

Interestingly, a major KiwiSaver provider has argued that too many Kiwi savers will miss out on investment returns by spending the rest of their working life in the conservative funds they have been defaulted to. The argument rests on these conservative funds returning less than more aggressive share-oriented funds over the longer term.

While past returns are not necessarily a good guide to future returns, the experience of the past two decades surely tell not to make sweeping assumptions about future relative returns. KiwiSaver members who have allowed themselves to be allocated to relatively conservative default funds have done pretty well over the past four years and it would be foolhardy for the Government, or a KiwiSaver provider for that matter, to somehow impose their conviction about future relative returns upon lethargic KiwiSaver members, or indeed presume to know what’s best for individual investors.

Bond yields are historically very low in most, though certainly not all, developed economies. The scope for them to go lower and thus keep delivering the significant capital gains they have done over the past two decades or so is getting pretty slim. Furthermore, if the liquidity central banks have been pumping into their economies finally generates economic lift-off, higher inflation is likely to follow, and that would dent future bond returns. Essentially central banks are trying to engineer an economic recovery by lowering the returns bond investors get in favour of higher returns for businesses taking on debt to expand their business or leverage their existing business – either way cheaper credit should translate into higher share returns eventually.

It would be a pity to see investors once again driven by hindsight to desert an asset class (in this case shares) as it passes through the bottom of its returns cycle and plump for bonds as they pass through the peak of their cycle. The shift back to shares delivering higher returns than bonds will happen – if only someone would tell us when!

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