Following the 2008 market decline, investors have been all too eager to replace equity exposure in their portfolios with non-equity exposure. Having lived through losing 50% of their equity values twice in a ten year period, many have decided that they have too much equity exposure in their portfolios. The key question is do these risk-avoiding portfolios have enough risk premium for investors to reach their long-term wealth goals?
A well-established method for estimating long-term returns is a building-block approach that combines estimates of inflation, the real risk-free rate and the risk premium to arrive at an estimate of total return. The inflation portion compensates an investor for the expected decline in the purchasing power of his home currency. The real risk free rate compensates an investor for deferring consumption. The risk premium compensates the investor for taking the risk of an investment.
The chart illustrates these long-term return estimates for a number of asset classes ranging from commodities to emerging market equities. One can estimate how much risk premium or total return any portfolio combination of these has. The final two bars on the right show a traditional diversified 60/40 equity/bond portfolio and a recently developed Risk Parity Portfolio (risk allocation of 25% equities/25% commodities/25% government bonds/25% credit). Using these estimates, the Risk Parity Portfolio has a risk premium of about 2.2%, well short of the 3.1% of the 60/40 portfolio.
Risk reduction – At what cost?
This is a unique time in investment history. Bond investing has never been more popular. Even the most followed investment gurus are bond investors. Why? Interest rates are at record lows and bond investors have seen capital gains beyond their wildest dreams. These gains came while avoiding the two 50% declines in ten years experienced by equity investors.
What role do bonds play in an investor’s portfolio? If an investor has a five year time horizon, a five-year zero coupon bond is a riskless investment. The return over five years is known with certainty. Over time, the riskless portfolio has been broadened to a diversified portfolio that holds US and non-US government and corporate bonds. The duration remains approximately five years, however, and its role in the portfolio remains the same. It is the modern version of the riskless asset for the five year time horizon investor. Allocations to it are used to reduce the volatility of an equity portfolio (30/70, 60/40 etc). Today that bond portfolio has a risk premium of 1.33%. The Risk Parity Portfolio, at 2.16%, has about the same risk premium as a 30/70 equity/bond portfolio. This means that the Risk Parity Portfolio, considered an alternative to a 60/40, is carrying essentially no more risk premium, or compound return horsepower, than a traditional retired person portfolio.
There are two ways to think about investment risk. The first and most common is how bumpy will the ride be. How much do I have to lose while on the path to winning? This is near term portfolio volatility. The second kind of risk, as those who have done multi-year simulations know, is the risk of wealth shortfall – of not having enough risk premium in the portfolio. This is the risk that the portfolio does not have enough wealth-producing horsepower to compound returns over time. This is shortfall risk. Selecting the right asset mix for an investor requires balancing near term volatility against shortfall risk.
For those who believe the world has changed and so eagerly replaced their equity exposures, we suggest they apply the risk premium test to their new portfolios. This will tell them the true cost to their wealth building of remaining “safe.”