Diversification is the only free lunch in finance

JP Morgan thinks the market is frothy. Goldman Sachs says valuations are justified by fundamentals. The fact that there’s still disagreement is encouraging. Bull markets tend not to die until the sceptics are ridiculed and there are no buyers left on the side lines.

The scale of the US stock market rally - up 46% since the October 2022 low, with income re-invested - is also unexceptional in historic terms. Looking back over the past 60 years or so, 18 bull markets have ranged from a 42% gain to as much as 169% in the late 1990s. This remains a baby bull.

And yet, some alarm bells are ringing. The number of markets hitting new highs is rising - the US, Japan, India, Europe. Gold and bitcoin are rising together, an unusual coincidence that smacks of investors simply buying what’s going up. US shares, which were valued at 15 times earnings in the autumn of 2022, are at 21 times today.

It’s unscientific, but I’m having more conversations with younger colleagues who roll their eyes because I’m not buying this or that ‘sure-fire’ bet. The seen-it-before red light in my head is flashing. Now feels like a good time to be thinking about investment risk.

The excellent Global Investment Returns Yearbook, put together for UBS by Paul Marsh, Elroy Dimson and Mike Staunton, tells you all you need to know about the risks and rewards of stock and bond investing.

Their first point is that both asset classes are volatile. We already knew that about shares, but during 40 years of falling interest rates we forgot that bonds can be too. If you’re in the right place at the right time - Germany and Japan during their post-war economic miracles, for example - you can make eye-watering returns from shares. But the losses can be staggering too - 70% in real terms for UK investors during the early 1970s oil shock, 65% in Germany during the dot.com bust, an 80% inflation-adjusted loss after 1929’s Wall Street crash.

For bonds, too, the variation in returns is striking. From 1982, when US Federal Reserve chair Paul Volcker drove a stake through the heart of the inflationary dragon, until 2014, the world bond index provided a real return of 7.4% above inflation. 

Bonds delivered a positive real return in 28 of those 33 years. But fixed-income investments can disappoint too. Between 1940 and 1981, US Treasuries fell by 67% and didn’t recover their pre-war value until 1991. They had spent more than 50 years underwater.

Risk, however, is not the same thing as volatility. Markets go up and down, but what matters is whether or not you crystallise a loss. Human nature being what it is, the chance of you doing that rises the deeper you drop below the prior peak and the longer you have stayed in the red. The volatility is not the problem, it’s our loss of nerve.

There have been some massive drawdowns over the years and some painfully extended times to recovery. It took 15.5 years for US investors to fully recover from the Wall Street crash. In real terms, it was more than a decade before markets regained their pre-oil shock level. Japan has taken 34 years to recoup what it lost after 1989, even in nominal terms.

For investors considering whether to invest after a strong rise in the market, a key question is how long they might be underwater if they got really unlucky and found themselves putting their money to work right at the top. The Global Returns Yearbook goes some way to answering that by looking back at a comprehensive range of holding periods in its 124-year database.

Analysing 115 10-year periods, 105 20-year spans, and so on, shows two things. First, the range of likely outcomes narrows significantly as the holding period extends. Second, the chance of a decent return increases the longer you are invested. Crucially, it shows that, for any given market, there is a number of years above which there are no instances of negative returns.

US equity investors have never held shares for 16 years or longer and lost money. In Denmark, Canada, Australia and South Africa, too, the longest period of negative real equity returns is under 20 years. The bad news is that in the rest of the world, you could have been less fortunate. A really unlucky Japanese investor could have spent 51 years underwater in inflation-adjusted terms.

The best way to minimise the risk of this happening is to diversify your portfolio. Nobel prize-winner Harry Markowitz famously quipped that diversification is ‘the only free lunch in finance’, allowing investors to increase expected returns while reducing risk. The benefits are variable. They are much greater for investors in small, concentrated markets than in large, lower-risk ones like the US. But diversification is always a good idea.

Sensible but not a panacea. The classic asset class diversification between shares and bonds worked well in the years after 2000 when they behaved differently from each other. For most of the 20th century, though, they were correlated to a greater or lesser degree. The experience of 2022, when both assets fell together, is less unusual than it felt at the time.

Fifteen years after share prices started to rise in the wake of the financial crisis, it feels like the current bull market is long in the tooth but still intact. The longer price rises go on, the lower our expected returns will be and the risk that we will spend some time underwater will increase.

But the risks an investor takes when putting their savings into the market have been well rewarded over time - a 5.3% a year real return for UK shares versus 1.4% for gilts and less than 1% for cash. Compounded year after year, that is a life-changing difference.

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Please note that the views expressed in this article are my own.