The negative returns across all asset classes have created a mentality of fear. And where investors normally look back over a long timeframe, this has now become compressed and is stopping them allocate on a more normalised medium-term basis, which is responsible for the 30-50% allocation to cash and short-term government bonds.
Investing with a short-term outlook gives a significantly lower stability of returns, as any volatility can heavily skew performance, and it becomes a bet on market timing rather thanm ore justifiable factors, such as yield.
Indeed, 50 years of market data, including through periods such as today’s, shows that investing on a long-term basis providesmore predictable returns. Fixed income should be a lower-volatility asset-class, and the yield you invest at should be a great guide as to what expected returns should be.
If you invest for a one-year period at a 3% or 6% starting yield, you have roughly the same range of annualised return outcomes, and the total range from -16% to +19% is material. So, the yield you invest at isn’t a great driver of expected returns over the short term – it only defines 40% of the annualised returns.
However, if you invest for three or five years the return is 80% to 90% driven by the yield you lock in at, and so your expected return is much more correlated and consistent.
Allocations to cash and cash substitutes are also very high right now, in some cases 30% to 50%.
We know that if investors are in cash, then all the good news is behind them as market pricing clearly shows cash rates going down over the next couple of years.
While they might look attractive in comparison to the last 15 years, your returns are going to deteriorate and ultimately disappoint, making it very difficult to achieve your financial goals going forward.
If we look at cash rates at the moment, and we compound those over the next three years, we only get a return of around 15%.
The main driver here is the need to reinvest all your principal and the interest earned at continuously lower yields – i.e. reinvestment risk.
But a bond portfolio that yields 7% provides compound returns over the same three-year period of around 23%. A bond portfolio that has a 10% yield returns 34% over that same three-year period. Investor returns are better because of the higher yield but also due to not needing to reinvest the principal.
The excess returns between cash and a 7% portfolio is 8 percentage points over three years or 19 percentage points for a 10% portfolio. And so, the big question is how are investors going to feel in three years if they could have had a 23% or 34% return, but only got 15%?
The current environment is very different to 2021. The change in monetary policy, as central banks have hiked rates, has created uncertainty in markets and price volatility.
The main protection you have as a bond holder against market volatility is the yield at which you buy your bonds, and this was very low in 2021. So, we had an environment where there was less protection, and a bigger change in the main driver of performance: monetary policy.
Today, bond markets have materially higher starting yields that provide significantly more protection. At the same time, central banks have already done a lot of the heavy lifting, so the risk of a similar round of rate hikes is much lower given expectations that central bank policy is at the peak already.
We know investing short term gives less certainty of performance. We know the Fed is saying yields will ultimately come down. We know reinvestment risk is materially greater in cash, and total return is more volatile as yields change. We know you get a better compounded return in bonds than in cash. And we know that from here a rally can happen quickly and materially impact investors’ returns.
And that is why we think we must continue to ask how investors are going to be thinking in three years’ time about what they’ve achieved, based on decisions they’re making today.