The equity risk premium – an article of faith or reality?

We see an increasing number of robo-advisers joining the investment community and offering model portfolios to investors based on a couple of questions to assess risk tolerance and then pigeonhole them into a model portfolio masquerading as digital advice. The leap of faith that seems to permeate these model portfolios is that equities are for the long term and fixed income provides all the diversification that is needed. But do the facts support such simplistic assumptions?

Let’s take the most successful equity market of the last 100 years – the US. As of the end of 2016, since 1920, the US stock market has generated pretty impressive total returns of 10.1%. Even in real terms, the 7.3% return has been a fantastic way to build wealth over the very long term. Emphasis on VERY long term.

However, individuals do not have a 100-year time frame for their investments. As an investor gets closer to retirement, they become more focussed on their investment portfolio. At this point when fear of being underfunded for their retirement sets in, capital preservation becomes more relevant. Thinking about equities in isolation is also a touch naive – we get a choice as to what we invest in. So, let’s look at equity returns in excess of what we could get in a bank account.

When we compare equity returns (and this is still the most successful equity market of the past 100 years) across time frames, the frequency of loss pattern becomes more obvious. On a 3 year rolling periods, 23% of periods were returns less than cash – on a 5 year view the proportion is still 22.6%. Even on a 10-year time horizon, equities underperformed cash in 16% of periods. Ok so this period includes a pretty major war and maybe that skewed the results so let’s take the data from 1946.

So, it definitely looks better but not that much. If you are a 55-year-old planning to retire at 65, are you OK with a 15% chance of having less money than you do now in real terms?

If there was a 5% chance that could be nearly a quarter less than you have now?

That’s why we have bonds though right?

The problem has been that when equities have had extended periods of poor returns, we also had rising cash and bond yields. It has been inflation that has been driving both assets higher.

Again, since 1946, for a 60% equities/40% bonds portfolio, 14% of 10-year periods generated negative real returns. This rises to 19% for 5-year periods and 23% for 3-year periods.

Building a model portfolio without having a view on how inflation will play out risks stranding investors with not enough assets to cover their retirement. Using simplistic portfolio construction exacerbates this problem. Unfortunately, nearly every robo-advisor relies on these simplistic principles under the guise of ‘advice’ in their offerings.

It isn’t just about how long until retirement, it is also about

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