What are the long-term expected returns for the different asset classes?
More than ever, asset allocation depends on risk tolerance.
IN A WORD:
Today, expected returns in the bond and money markets universe are very low or even zero.
It is the first time in history that expected returns have been so low, especially in real terms, as inflation remains positive in both the United States and Europe.
Expected returns on riskier investments remain broadly in line with historical standards, especially as we are approaching the end of the bull market cycle that has lasted more than 10 years.
Investors have two options today:
- Either to prefer a no-risk long-term return that is lower than inflation in the fixed income investment universe,
- Or to take on more risk and allocate more to equities and alternative investments in the broader sense.
Our strategic asset allocation decisions continue to favour:
- long-term investments (increased duration)
- risky investments (equity markets and real assets, such as real estate, commodities, etc.).
Comparison of long-term expected returns in 2019 vs 2015
Conclusions from these two charts:
1) The first remark is visual: expected returns are more ‘out of step’ in 2019 than in 2015, moving away from the regression line.
2) The decline in expected yields in the bond universe is spectacular:
- An extraordinary performance over the period that cannot be repeated in the future. On the contrary!
- A slowdown in overall economic growth, a general erosion of inflation and, above all, exceptionally accommodative monetary policies during this economic cycle. Monetary policy will not be tightened for several years because the ECB's and BoJ's Quantitative Easing continues. Interest rates will remain low for a long time. They have not been so low since the end of the Second World War.
3) Expected returns on riskier investments are significantly higher than the so-called ‘no-risk’ investments. This is logical, and financial theory justifies it. But this gap (‘risk premium’) is much larger nowadays than in the past. Premiums for equity markets of developed countries increased from 4% to 5.5% between 2015 and 2019 and can be compared with the historical average of around 4%.
4) Expected returns on risky investments are around 1% lower today than they were 5 years ago. We are very near to the end of the economic and financial cycle.
5) To adapt to this environment, without listening to short-term noise, in other words, by focusing solely on the long term, investors should:
- extend the horizon of their investments;
- accept more risk in their investments in Corporate bonds (lower quality while remaining diversified);
- increase the pocket of equity markets which generate higher dividends than bond yields; and
diversify into real and alternative assets.
We recommend returning to a long-term strategy that works well: take advantage of price declines when they occur, in order to strengthen investments in risky assets.
This helps to makes the link between the long-term view explained in this paper and the more practical decisions which must be taken on a daily basis.