Avoiding risk is not the way to make money
In yesterday’s FTfm, Pauline Skypala published Stuart Fowler’s response to Zvi Bodie’s “safety first approach” that featured in last week’s piece “Reassurance for the Vanguard ‘Bogleheads”. The original can be found on the FT website by searching “Avoiding risk is not the way to make money” but has also been detailed below for ease.
The debate about equity risk, and who can afford to bear it, usually crops up in FTfm in the context of defined benefit pension funds. Last week Pauline Skypala drew attention to an influential academic voice in personal investment planning, Zvi Bodie of Boston University. Championing a “safety first” approach, Professor Bodie believes that if people were told how bad real equity returns can be and for how long, they would choose to replace equity bets with inflation-indexed government bonds. Our experience, with a business model that is indifferent to clients’ choices, does not bear this out.
It looks a reasonable assumption. Imagine your unbiased financial adviser walks you though a set of charts showing the cumulative real returns for between 50 and 110 years of the UK, US, Japanese and European markets. She shows you the grisly 20-year period since the Japanese market peaked at twice its long-term trend, subsequently languishing at about half the trend. But many other 20-year periods from market peaks are also flat or even negative. Even from an extreme low, in the 1974 bear market, she could point to a decade of flat returns, adjusted for the then high inflation, from continental Europe. You hardly need the American Great Depression to complete the picture.
All this history should be embedded in the assumptions about future real return probabilities underpinning investment advice. But this is only half the story. Investors also need to be told what it costs to avoid all forms of equity-related risk.
Prof Bodie is right to point out that individuals have a near perfect hedge for both inflation and economic risks, in inflation-indexed government bonds. Substituting risky assets by the risk-free hedge, it is possible to quantify the cost and benefits of avoiding equity risk, in the shape of a narrower and lower range of probable outcomes. Safety first must deal with “lower” as well as “narrower”.
Clients given both sets of unbiased information make different choices from those assumed by academics. We plan and manage goal-based portfolios for individuals using a process that closely follows Prof Bodie’s ideas about the economics of lifetime financial planning for households, as well as his text-book solution for combining risky portfolios and a risk- free asset. Our real return probability ranges for the risky portfolio, which is globally diversified, are realistic, conditional on where markets appear to be in relation to sustainable trends, specific to every time horizon, and the ranges increase with time. Duration-matched index-linked gilts are our risk free substitute.
Clients’ exposure to inflation-indexed risk free assets happens to be 36 per cent, but that largely reflects the average of their ages and risk preferences. Behind it lies a typical planning process. Conversations start with a safety first bias and then move away from it, in favour of deliberate risk-taking for longer horizons, because clients value the pay-offs. It is not because they are all young or very rich. They mostly have different goals competing for capital that risk-taking can help resolve. Even the wealthiest, who really can afford the high price of avoiding all equity risk, will not pay it because they believe that their capital (like their heirs) should not be lazy or inefficient.