What asset should you buy if you want to avoid risk? It is not a simple question.
Philip Coggan: Buying a reliable lifeboat is a risky business
What asset should you buy if you want to avoid risk? It is not a simple question.
By Philip Coggan
Published: June 9 2006 23:02 | Last updated: June 9 2006 23:02. Copyright by The Financial Times
Traditionally, investors have talked about the government bond yield as the “risk-free rate”. But many generations of bond investors have been wiped out, sometimes by outright default, at other times by roaring inflation.
Cash can also be classed as risk-free but it too is subject to the effects of inflation. Real rates have at times been negative and this is especially so when risk is taken into account.
Gold has its devoted band of admirers and its very long-term record, relative to paper money, has been good. But it pays no yield and there have been decades (the 1980s and the 1990s, for example) where the price has gone nowhere.
Arguably, the only true riskless asset is index-linked government bonds. But these have largely been launched in an era of declining inflation. Governments’ willingness to service such debt in a world of double-digit inflation has yet to be tested.
Perhaps there is nothing truly without risk in the sense that it cannot be confiscated, stolen or subject to price variations that can ruin those with poor timing.
Another measure of risk is volatility, the amount by which prices move around over a given period of time. But volatility is an odd thing; nobody really minds upward volatility (sharp price rises) but they do care about it when prices are falling. However, the statistics can make an asset that rises between 2 and 10 per cent a month look more risky than one which alternates 0.1 per cent falls with 0.1 per cent rises to deliver a zero return.
Investors also need to think about the time scale of volatility. Eric Lonergan, the Cazenove strategist, makes this point about the difference between cash and bonds.
On a daily basis, cash is clearly less volatile than bonds. But that is not true for investors with a 10-year horizon. The returns from cash will be very uncertain because short-term interest rates fluctuate whereas a government bond investor who holds until maturity can be virtually certain of his return, in nominal terms at least.
Traditionally, government bond yields have been seen as a combination of two factors. The first is the expectations of future changes in short-term interest rates (which, in turn, is driven by inflation forecasts). The second is a premium for uncertainty.
But, Lonergan argues, if inflation is expected to remain low, then future interest rates should be around current levels. And, given the volatility point made earlier, there needs to be no premium for uncertainty.
If that is the case, then a flat yield curve (short rates at the same level as long rates) or an inverted yield curve (short rates higher than long rates) will not be a signal of economic weakness, as it has been in the past. It will simply be normal.
Another point emerges from Lonergan’s analysis. What investors should really worry about is covariance; whether or not the asset moves in the same direction as the rest of the portfolio.
It is not enough simply to buy a wide range of different assets. In recent weeks, for example, we have seen that commodities and emerging markets have sold off in unison; while owning a geographical spread of leading equity markets has offered little protection. Sometimes investors can be making the same bet via several different assets; in this case, on robust economic growth.
The beauty of government bonds is that they tend to pay out well when other assets are doing poorly – most notably in a recession. In this respect, they are rather like an insurance policy that pays out when the investor needs it most. That makes them worth owning.
This argument can also be used to justify holding gold within a portfolio: gold seems likely to perform best when confidence in paper assets (including equities and bonds) is weakest. Recently, however, gold has been, as with other commodities, more of a speculative play on global growth.
The Swiss franc (and Swiss government bonds) is another asset class that investors tend to turn to in times of uncertainty. The trouble is that Swiss assets are priced accordingly. Swiss 10-year bonds offer a yield of just 2.7 per cent and Swiss three-month interest rates are around 1.5 per cent.
Fund manager Jonathan Ruffer argues that Norwegian government bonds are just as safe (thanks to the country’s oil revenues and political stability) as Swiss bonds but they at least offer yields of more than 4 per cent.
What other assets might one hold if one was risk averse? Lots of investors are very keen on property but clearly prices have been driven sharply higher in recent years.
Those who believe in rapid climate change might be looking to buy land a long way from the coasts, in the middle of the US or Canada say. But as this is an expensive insurance policy, this can only be an option for the very wealthy or the seriously alarmed.
Those who are worried about inflation might look at other real assets apart from commodities, such as art or wine.
But the key is not to get overcommitted to one asset class (such as many people did with equities in the 1990s) or on one view of the world, whether it be an imminent recession or soaring inflation.
It makes sense to insure against the possibility that you might be wrong and to hold assets that will bale you out in crisis conditions. Eliminating all risk is probably impossible but that is not to say risk cannot be reduced.
philip.coggan@ft.com
What asset should you buy if you want to avoid risk? It is not a simple question.
By Philip Coggan
Published: June 9 2006 23:02 | Last updated: June 9 2006 23:02. Copyright by The Financial Times
Traditionally, investors have talked about the government bond yield as the “risk-free rate”. But many generations of bond investors have been wiped out, sometimes by outright default, at other times by roaring inflation.
Cash can also be classed as risk-free but it too is subject to the effects of inflation. Real rates have at times been negative and this is especially so when risk is taken into account.
Gold has its devoted band of admirers and its very long-term record, relative to paper money, has been good. But it pays no yield and there have been decades (the 1980s and the 1990s, for example) where the price has gone nowhere.
Arguably, the only true riskless asset is index-linked government bonds. But these have largely been launched in an era of declining inflation. Governments’ willingness to service such debt in a world of double-digit inflation has yet to be tested.
Perhaps there is nothing truly without risk in the sense that it cannot be confiscated, stolen or subject to price variations that can ruin those with poor timing.
Another measure of risk is volatility, the amount by which prices move around over a given period of time. But volatility is an odd thing; nobody really minds upward volatility (sharp price rises) but they do care about it when prices are falling. However, the statistics can make an asset that rises between 2 and 10 per cent a month look more risky than one which alternates 0.1 per cent falls with 0.1 per cent rises to deliver a zero return.
Investors also need to think about the time scale of volatility. Eric Lonergan, the Cazenove strategist, makes this point about the difference between cash and bonds.
On a daily basis, cash is clearly less volatile than bonds. But that is not true for investors with a 10-year horizon. The returns from cash will be very uncertain because short-term interest rates fluctuate whereas a government bond investor who holds until maturity can be virtually certain of his return, in nominal terms at least.
Traditionally, government bond yields have been seen as a combination of two factors. The first is the expectations of future changes in short-term interest rates (which, in turn, is driven by inflation forecasts). The second is a premium for uncertainty.
But, Lonergan argues, if inflation is expected to remain low, then future interest rates should be around current levels. And, given the volatility point made earlier, there needs to be no premium for uncertainty.
If that is the case, then a flat yield curve (short rates at the same level as long rates) or an inverted yield curve (short rates higher than long rates) will not be a signal of economic weakness, as it has been in the past. It will simply be normal.
Another point emerges from Lonergan’s analysis. What investors should really worry about is covariance; whether or not the asset moves in the same direction as the rest of the portfolio.
It is not enough simply to buy a wide range of different assets. In recent weeks, for example, we have seen that commodities and emerging markets have sold off in unison; while owning a geographical spread of leading equity markets has offered little protection. Sometimes investors can be making the same bet via several different assets; in this case, on robust economic growth.
The beauty of government bonds is that they tend to pay out well when other assets are doing poorly – most notably in a recession. In this respect, they are rather like an insurance policy that pays out when the investor needs it most. That makes them worth owning.
This argument can also be used to justify holding gold within a portfolio: gold seems likely to perform best when confidence in paper assets (including equities and bonds) is weakest. Recently, however, gold has been, as with other commodities, more of a speculative play on global growth.
The Swiss franc (and Swiss government bonds) is another asset class that investors tend to turn to in times of uncertainty. The trouble is that Swiss assets are priced accordingly. Swiss 10-year bonds offer a yield of just 2.7 per cent and Swiss three-month interest rates are around 1.5 per cent.
Fund manager Jonathan Ruffer argues that Norwegian government bonds are just as safe (thanks to the country’s oil revenues and political stability) as Swiss bonds but they at least offer yields of more than 4 per cent.
What other assets might one hold if one was risk averse? Lots of investors are very keen on property but clearly prices have been driven sharply higher in recent years.
Those who believe in rapid climate change might be looking to buy land a long way from the coasts, in the middle of the US or Canada say. But as this is an expensive insurance policy, this can only be an option for the very wealthy or the seriously alarmed.
Those who are worried about inflation might look at other real assets apart from commodities, such as art or wine.
But the key is not to get overcommitted to one asset class (such as many people did with equities in the 1990s) or on one view of the world, whether it be an imminent recession or soaring inflation.
It makes sense to insure against the possibility that you might be wrong and to hold assets that will bale you out in crisis conditions. Eliminating all risk is probably impossible but that is not to say risk cannot be reduced.
philip.coggan@ft.com
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