How much extra should you expect to receive for watching your investments go up and down?

It is no secret that 2022 was a difficult year for investors. It came however on the back of a decade that is now seen as a golden period for investment. So, how do we put the current difficulties into a long-term context?

We can use an interesting set of data curated by New York University that records the annual performance of three major “asset classes”, shares, bonds and cash from 1928 to 2022*. The numbers are specific to the U.S. market but, given the size and importance of the U.S. market, they are also a good approximation for a UK investor in global markets.

Most investment portfolios, including those offered to our clients, will contain a mix of shares (equities), bonds and cash in order to diversify and spread investment risk. The returns for these asset classes in 2022 demonstrate the turbulent year we have just experienced:

• Shares (S&P 500 stock market index): -18.0%
• Bonds (fixed interest 10 year U.S. government): -17.8%
• Cash (3 month treasury bills): +2.0%

In a “normal” year, we would expect to see the returns from shares and bonds moving in opposite directions so that any falls in one would be compensated by gains in the other. The exceptional circumstances of last year saw both bonds and shares falling as they reacted to a cocktail of rapidly increasing interest rates, high inflation, war in Europe and economic slowdown.

Historically shares and bonds have higher long-term returns than cash but, as we saw last year, it’s not out of the ordinary for cash to be the best asset class in a single year, in fact it’s happened 14 times over the past 95 years.

Bonds have performed better than shares 35 times in a calendar year since 1928. Cash has beaten shares in 31 out of the past 95 years. The S&P 500 return has been negative in 26 of the last 95 years. Bonds were negative in 19 of those years.

The Investor’s challenge

Cash gives you short-term peace of mind but low expected long-term returns. Shares provide protection against inflation over the long-term but they can fall in the short-term. Bonds are somewhere in the middle which is why they are useful for diversifying and limiting risk in a portfolio.

So, what can you expect on average over the long term from these popular asset classes? After adjusting for inflation, the average annual real return over the last 95 years is as follows:

• Shares: +6.5%
• Bonds: +1.5%
• Cash: +0.2%

Measured over multi-decade periods, we can assume therefore that shares will perform better than bonds and bonds will out-perform cash. We can also see that it is possible that cash or bonds can beat shares over a year or even a period of several years.

The volatility premium

Shares go up for many reasons but one of the biggest ones is that they can also go down. The additional long-term return you expect to earn on shares compared to say cash is called the “volatility premium” and is effectively the reward you earn for the discomfort of watching when inevitably the value of your shares falls.

*Source: Historical Returns on Stocks, Bonds and Bills: 1928-2022

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

The value of investments may fall as well as rise. You may get back less than you originally invested.