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Adding equities to the asset equation

We concluded last week&#39s discussion by examining the merits of investing in commercial property as a core part of an investment portfolio. We compared the benefits of property against the alternative asset classes we have already considered.

It now remains for us to add the final asset class – equities – to this series of articles but not before we have added property investing to the correlation grid we have built up so far.

You can see from the grid (below) that commercial property investment has been very lowly correlated with all the other major asset classes considered so far, with the exception of the perfect correlation with itself, which is an obvious but integral part of the grid.

Should this be surprising? Hardly. Why should either rental income or property values depend on the rate of return available at any given time on short-term cash deposits or short-term fixed-interest investments? Correlation with long-term fixed-interest investments – shown as being relatively low in the grid – is almost certainly prompted by the broadly similar investment features of a known level of income with a secure or, at least, reasonably secure capital value.

Correlation with index-linked investments comes from the general long-term trend for property values to rise broadly in line with price inflation although, historically, a little faster than that index.

The message? Low correlation means that property should, when combined with one or more of those other assets, reduce the overall volatility of the portfolio while increasing average returns.

Property has produced higher returns than the other asset classes over the last 20 years, as we have already noted, with the exception of fixed-interest gilts.

However, the real key to the vast majority of investment portfolios is equities. Even before we look at the completed comparative performance and volatility chart, including all the asset classes so far discussed and adding in UK and overseas equities (right), you will without doubt anticipate correctly that we will find historical investment returns higher than any other mainstream alternative investment but volatility equally at the top end.

On the one hand, you would have been right to anticipate the relatively high volatility of UK equities, as standard deviation statistics show them to be more volatile than almost all the other asset classes. On the other hand, you might be surprised to note not only that there has been little difference in the volatility of equities and long-dated fixed-interest gilts but also that gilts have, on occasion, fluctuated to wider extremes away from their average than have equities, with a highest rise of 54 per cent against 36 per cent and a worst fall of 12 per cent against 10 per cent.

One might question, then, the merits of investing in fixed-interest gilts compared with equities – higher volatility yet lower returns. But it should be remembered, as we are always told, that past performance is not necessarily a guide to the future. Or, to use an analogy, Carlisle United are just as likely as Manchester United to win the FA Cup next year.

Turning our attention to overseas equities, it is easy to note that the average performance has not been as bright as UK equities but higher than all the other major asset classes. As marked a difference, however, is historical volatility, as overseas equities have provided investors with a much bumpier ride than their home-based equivalents. This is less to do with the noted temperament of volatile foreigners compared with the dependability of the Brits than the impact of currency fluctuations. If sterling strengthens against foreign currencies, then any strong performance in the stockmarkets of those countries will be reversed, at least in part, when its value is converted to sterling.

Put simply, it then takes more units of their currency to buy £1 than had previously been the case and so, even with more of those units, the sterling equivalent may be lower.

This dual impact of overseas equity performance and currency exchange rates most vividly surfaces where those overseas equities perform better than UK equities and their currency strengthens against sterling. This is a double benefit when comparing the performance over UK equities for UK-based investors or, vice versa, weak equities and currency.

All this, then, helps our consideration of the relative merits of UK and overseas equities in a portfolio to some extent but only to some extent. Far too glib, I fear, is the suggestion of many investment advisers that a client should have some of their portfolio in overseas equities so as to diversify their holdings and thereby reduce the overall risk profile. This, as I have stressed so many times during this series of articles, can only be true where the two assets in question here – UK and overseas equities – are lowly correlated.

How highly – or otherwise – have these two assets been correlated? Fortunately for the aforementioned advisers, the performance of overseas equities has been sufficiently different from UK equities to confirm that diversification between the two assets does indeed reduce portfolio volatility.

This is perhaps best illustrated by looking at the number of years over the last couple of decades where the performance of these two categories of equities has shown at least 10 per cent performance difference (below).

Certainly, there is some evidence of low correlation. But it should be noted that only once in the last 20 years has a fall in one area been countered by a rise in the other.

Final chapter next week before we move back to pensions, not least with developments in some major court cases which stand to change the pension market more comprehensively than stakeholder – also known as personal pensions with low charges for those who have never believed the great hype that a new dawn is nigh.

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