One of the greatest challenges facing advisers in this low interest rate, low inflation, low growth environment is to encourage investors to look again at diversification.
The two easy options for investors – put the money ‘safely’ under the mattress or into a bank deposit account – may be beguiling but are usually not efficient.
So how do we sell diversified portfolios? Recent research, conducted with more than 520,000 clients of financial advisers, reveals that the average investor’s risk tolerance is consistent with a 50/50 growth/defensive portfolio.
There are two key facts that we know about diversification: first that it is most likely to maintain the client’s purchasing power over time and second that, for the moment at least, the portfolio solutions that best match common sense also meet the FSA’s concerns for simple, explicable and low-cost criteria.
Perhaps one of the best ways to present the argument for diversification is to look at the erosive effect of inflation on purchasing power over the longer term, starting by looking at some of the most recent experiences.
In the past 10 years inflation has averaged 3 per cent per annum but over the past 40 years it has averaged closer to 7 per cent per annum. At 7 per cent the value of money ‘safely’ invested under the mattress halves every 10 years. So £10,000 reduces to approximately £5,000 in 10 years and to a little over £2,500 in a further 10 years and so on.
The standard bank deposit account is no longer a safe haven against inflation, if it ever was. Over the past 40 years it has averaged 8.5 per cent per annum, or a real return of 1.5 per cent. Over the past 10 years the real return has been marginally higher at 2.1 per cent per annum, the average return 5.1 per cent per annum and inflation has been at 3 per cent.
After any personal taxes, purchasing power is likely to be flat at best, and currently rates are even lower.
This is, of course, a snapshot of the past. The past is unlikely to be replicated in the future. However, it does provide us with a mechanism to better frame clients’ expectations.
We will not see particular asset classes behave in the same way in the next 10 to 20 years as we have in the past 40, if for no other reason than we have lived through a secular bull market in longer dated fixed interest, which cannot be replicated from our position with current bond market yields as they are.
From here there is a reasonable likelihood of interest rates remaining stable or increasing. Neither scenario enhances the investment return on fixed interest above the pedestrian.
If we look at the performance of a theoretical 50 per cent growth asset and 50 per cent defensive asset portfolio over the past 40 years we can see that the average real return was 5.9 per cent each year. Over the past 10 years it reduced to 3.5 per cent each year. If £1,000 had been invested over a rolling 10-year period then the average real return over the past 40 years would be £1,866 and £1,431 if invested over the past 10 years.
Diversification paid dividends in the past. There is no reason for it not to in the future. The alternatives of mattress investing or term deposits are, in comparison, significantly higher risk.
Paul Resnik is director and co-founder of FinaMetrica