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Asset Allocation: Risk and Return

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The first thing a historical perspective tells us is that, by and large, investment in equities outperform investment in either cash or bonds.

Take the United States. Here you can see both the nominal and the real return on the three asset classes since 1945.

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And here is data for the same time period for the United Kingdom.

You can explore the reasons why equities tend to outperform the other asset classes in the next section. But, remembering our risk/return mantra, ‘the higher the returns, the greater the risk’, the obvious question to ask is: at what cost, in terms of the risk the investor takes on, do you get these higher returns?

The price you pay for the higher returns equity investments offer is that equity investments are riskier than bonds or cash. What do we mean by this?

What we mean is that, over shorter holding periods, the variability of returns on equities – the highs and lows – are a lot more extreme than those on bonds or cash. The graph below, which shows the maximum and minimum real returns on our three different US asset classes over different holding periods, clearly makes the point. But notice as well that, the longer the holding period, the less variable the returns on equities.

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The higher return on equities to compensate for the higher variability of returns (their riskiness) is referred to as the ‘equity risk premium’, and it varies with the time period you choose to look at and with what you are comparing equities against.

Promoters of stock market investing tend to pick the highest premium in their ‘educational’ material. But whatever the size of the spread, a premium certainly exists – and it exists because equities are always going to be a much more uncertain investment proposition than a government bond, Treasury bill or deposit account. Again, you can explore why this is in the next section.

   



Equity Risks
Bond Risks

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