The Biased History that Drives Excess Allocations to Equities

“I have a friend who has amassed a fortune in excess of $100 million. He taught me two basic lessons. First, if you never bet your lifestyle, from a trading standpoint, nothing bad will ever happen to you. Second, if you know what the worst possible outcome is, it gives you tremendous freedom. The truth is that, while you can't quantify reward, you can quantify risk.”
Larry Hite

Three subtle biases in the way investors view historical equity returns lead to inappropriately high equity allocations.

To understand those biases and their pernicious effect, let’s start by reflecting on how investors typically view risk and return.

One of the mantras that Wall Street frequently promotes is that for investors with long horizons, equities are the best investment. The data supports that mantra. Figure 1 shows the progression of a dollar invested in the S&P 500 (proxy for equities) and U.S. 10-year government bonds (proxy for the so-called risk-free/safe assets) over the past 150 years. U.S. equities generated an annualized return of 9.0% and bonds 4.6%.

Figure 1: Nominal Value of $1 Invested in S&P 500 and US Govt Bonds Since 1870

Source: Data from Robert Shiller, MAEG’s calculations

The returns shown above are nominal returns, i.e., they are not adjusted for inflation. However, as investors, our primary concern is with the ability to grow our wealth at inflation-adjusted rates, i.e., real and not nominal rates of return. A rate of return, no matter how high, that is below inflation, will result in a decrease in the purchasing power of the portfolio and thus is equivalent to real wealth destruction. Consider that Venezuelan equities are one of the strongest performing equity markets in 2020, with year-to--date return of 256%1. However, during this period, inflation in the country has averaged at 3,000% annualized2.

Figure 2 shows investment performance of the S&P 500 and U.S. 10-year bonds over the past 150 years adjusted for inflation. As is seen, equities, as evidenced by the S&P 500, have generated extremely healthy inflation-adjusted returns of 6.9%. Indeed, the equity portfolio value as shown by the black line, is extremely steady in its upwards march.

Figure 2: Real Value of $1 Invested in S&P 500 and US Govt Bonds Since 1870

Source: Data from Robert Shiller, MAEG’s calculations

These investment returns are why long-term investors are told to maximize their equity allocations. However, the numbers and charts presented thus far tell us nothing about the risk.

Let’s now turn our attention to the risk of investing in equities.