The question is important because the investment environment appears to be turning from one of widespread deflationary expectations to one in which inflation may become more pressing.
To paraphrase Warren Buffett, it is exactly the type of environment in which one sees who has been “swimming naked.”
Most risk analysis tools in the investment industry are built on a generally-accepted scale of asset-class risk: this starts at the ‘lowest risk’ end with short-dated developed market government bonds and cash, rising through longer-dated and higher-yield bonds, to equities and finally commodities and smaller companies and emerging markets, as depicted in the image above.
In practice, this means that lower-risk investors have a higher weighting in areas such as government bonds, with low exposure to the stock market and other higher-risk assets. However, there are real and increasing problems with this approach, most notably asset pricing.
In many cases, asset prices have been distorted by central banks, skewing the risk/reward of certain asset classes. This is most obvious in government bonds, but has also been felt in corporate bond markets, and in equity markets through the phenomenon of the ‘bond proxy’. The standard risk/reward curve makes no sense as a basis for establishing an appropriate portfolio for an individual if it takes no account of price.
In illustrating how anomalous the prevailing monetary situation is, investors might look back over the last 120 years. Since the start of the 20th century, the average long-term interest rate has been 5.6%. Even excluding the period of high inflation from the 1970s to the 1990s, it is 4.3%. At the time of writing, the 15-year UK gilt had a yield of 1.5%, and would therefore require a drop of 28% to move to that (lower) long-term average. For longer-dated bonds, the difference is even starker: 50-year gilts would require a 50% drop in price to move to their long-term average.
