Long-term Returns and the Dangers of Complacency

Updated: May 18



From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.


Recently I was drawn to the headline on Professional Adviser, “Define volatility as ‘likelihood of reaching your goal’”. The article was a synopsis of views expressed at the latest gathering of the PA360 panel which comprised industry experts Graham Bentley, Philip Marti n and Peter Toogood.

"You can be unlucky with your timing but don’t compound the problem"

I certainly like the idea of defining volatility in terms of whether you reach your investment goal, rather than short-term volatility. The former risk relates to permanent loss of capital – if you fail to achieve your goal then the shortfall is one you can never make up. Short-term volatility on the other hand should simply be viewed as a cost of seeking to achieve your long-term goal rather than a risk to be avoided – unless you have an absurdly unambitious goal your portfolio will always have its ups and downs from year to year.


Bentley commented, “Depending on what kind of client you have – whether you’re in the accumulation phase or whatever you want to call it – volatility can essentially disappear over time. If you measure volatility by the degree to which your end result varies from what you might expect it to be, then that is purely the case. Explain that markets do go up and down and then find a way to give exposure to those markets in a sensible way – try to control it in the context of the risk that someone is prepared to take”.


While I commend the panellists’ views in relation to their proposal to adopt a healthier definition of volatility, I wonder if their comments require some qualification. Are they right to suggest that ‘volatility can essentially disappear over time’? The nub of their argument appears to be that while short-term ‘risk’ can be material, risk over the long term tends to zero.


According to Wikipedia, there are 175 cognitive biases that distort our thinking. One of these is ‘availability heuristic’, our tendency to remember things that happened recently more easily than things in the distant past. Thus, we might for example remember how financial markets have behaved in recent decades but not earlier. We also have a tendency to focus on things in our vicinity rather than far away, known as ‘mere exposure effect’. Thus, for example, we might think more readily about financial markets either side of the Atlantic than those on the other side of the world.


A US Treasury investor would have lost 48% of his real capital from 1900 to 1920, a period of 20 years. Had he begun investing in 1940 he would have lost 63% over the next 41 years. In Japan, an equity investor starting out in 1989 would have seen a decline in the real value of his portfolio of 70% over the next 22 years. Safe haven bonds generally comprise a significant portion of a retirement fund. In early 1989, the Japanese equity market comprised 45% of world total – today it’s 7%. Not only should clients be aware of the risks of markets not behaving as we generally expect them to over the long term but, more importantly, they should be informed of the very real risk of long-term goal failure that confronts us all today – famed investor Jeremy Grantham warned only last month that, “the stock market will ‘break a lot of hearts’ in the next 20 years”.


With the 30-year inflation-linked Gilt yield of -1.8% currently, your total real return to maturity is a loss of 42.1%. Furthermore, there is no risk to this scenario – the real loss is guaranteed. In fact, real losses on straight (nominal) Gilts would be even worse than those on linkers if inflation over the longer term is higher than the 3.4% currently anticipated, which it might well be.


In 1992, the yield on the 30-year linker reached 4.6% which meant a total real return to maturity of +286%. It is possible that our judgment about future returns from Gilts is being clouded by their fantastic returns over the last few decades.


Perhaps counter-intuitively, there is less of a risk for equities – hang on, aren’t equities supposed to be riskier than bonds? Companies may well experience the same headwinds that would crucify real bond returns such as higher inflation, but they can do things to mitigate their effect: they can adjust selling prices, capital expenditure or expenditure on labour among other things. Bonds, with their fixed coupons, do not have this luxury.


What can be done to address the possibility that future real returns from traditional asset classes may not be as good as they have been in recent decades? In my view, possible solutions fall into two categories: those that require action now and those that require action along the way.


‘Action now’ means accepting that traditional safe assets such as Gilts or Treasuries are no longer safe and that for safety you need to look elsewhere. Examples might include infrastructure trusts or defensive equities such as Unilever or National Grid. Note that these will exhibit higher short-term volatility than safe haven bonds but, as the panellists note, it is long-term goals that are important. Infrastructure trusts that yield 4% and whose revenues are explicitly linked to inflation – yes, they do exist – have a very good chance of returning more than -1.7% per annum in real terms.


‘Action along the way’ means responding appropriately to draw-downs in portfolio value that may occur on your journey towards your goal. If long-term returns are going to be lower than they have been in recent decades, you’d expect the draw-downs either to be bigger or more frequent, or both. Responding to them in the right way is paramount.


A 1994 paper by aeronautical-engineer-turned-financial-planner Bill Bengen makes exactly this point. His study of balanced funds over the 20th century found that so-called “black hole” clients – clients whose portfolios were impacted by a period of particularly poor equity market performance early in retirement – would have been best served by increasing their equity exposure to 100% following such a period. Bengen writes, “Admittedly, increasing stock allocation to 100 percent after a long period of miserable returns requires unusual foresight and fortitude on the part of the adviser, as well as the client. If you can convince your client just to maintain the 75 percent allocation under such conditions, you have won a major battle. However, the client is still faced with a shorter-than-average portfolio longevity, and with much less wealth to pass on to heirs than originally hoped for.”


In other words, you can be unlucky with your timing but don’t compound the problem.


I would not advocate 100% equities for anyone in retirement under any circumstance. However, I absolutely endorse responding to poor market performance in the right way. Indeed, we at Seneca spend a great deal of time looking for alternatives to expensive safe haven bonds, as well as being ready to increase risk exposure, perhaps significantly, to take advantage of any weakness in financial markets.


Published in Investment Letter, May 2019





The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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