It has long been the belief that younger savers should hold more equities and take more risk and that as people near retirement, they should play it safer with bonds and cash. But in a world of near zero interest rates, could this behaviour actually be risky? Can diversification play a powerful role?
Our policy paper The Curse of Long Term Cash showed that holding too much cash has cost savers billions in lost potential gains, and that the value of savings can be eroded by inflation. Investors are now faced with the combination of low interest rates and higher life expectancy. People need their retirement savings to grow for much longer, so clearly holding too much cash might be risky.
So what about bonds? Are these any better than cash as a store of value? At the moment we’re experiencing near zero interest rates, but if we see higher inflation and then interest rates rise, bonds are vulnerable to losses.
What people nearing or in retirement need are products with both bond-like low volatility but better returns than bonds. They need peace of mind that their savings can both withstand market downsides and capture market upsides. Diversification could be the answer.
The chart below shows the benefit of diversification in terms of risk and return for different asset allocation benchmarks. You’ll see that a conservative strategy holding mostly bonds and cash has an expected low risk of around 4% per annum, but also a low return of less than 1% above inflation. By diversifying, and reducing the bonds and cash allocation to 75% combined with 25% of assets in equities, property and commodities, far better expected returns are achieved with very little increase in volatility.
Source: Expected risk and return based on RLAM’s medium term capital market assumption as of March 2017. *Please note that this does not reflect the actual performance of the RL Funds and should be used for information purposes only, not as a reliable indicator of future performance.
The chart also shows that a pure equity portfolio would be expected to generate returns of around 7% above inflation, with historic risk of around 17%. Again, if the portfolio was diversified and 10 to 25% was allocated to Store of Value assets, retirement savings could potentially receive equity-like returns but with far lower expected volatility.
Ultimately, we believe de-risking can be risky. If pensions portfolios are invested only in cash and bonds then the risk might look low, but so too could the returns. Diversification of multi asset funds can play a powerful role by offering both lower volatility and higher returns.
Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.). The views expressed are the author’s own and do not constitute investment advice.
Investment Director, RLAM
Nersen Pillay is Investment Director in the Multi Asset team at Royal London Asset Management. Nersen works on tactical asset allocation and the communication of investment strategies.