Brent Sheather: Diversity key in protecting your nest egg

Shares are known as real assets but it can take a very long time to reap their benefits. Photo / Thinkstock

Two weeks ago, we looked at the highs and lows of inflation and deflation in the major Western economies from the beginning of the last century to the end of last year.

This was thanks to the research efforts of London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton, writing in this year's Global Investment Returns Yearbook (GIRY).

Over that period in the 21 countries in the GIRY database inflation averaged 5.3 per cent a year, with Switzerland having the lowest average rate at 2.3 per cent a year, Italy the highest at 8.4 per cent a year and New Zealand scoring relatively well at 3.7 per cent a year.

Most New Zealanders retiring today are wary of inflation as they lived through the very inflationary period of the 1970s and 1980s, peaking at 16 per cent in 1979.

Even at 2.5 per cent a year, over the average investment horizon of 20 years of a retiree the real value of one's savings and income would fall by more than 60 per cent.

Needless to say inflation-protection is high on the agenda of many people contemplating where to put their retirement nest egg, when they have the dual objectives of maximising income and leaving something for the kids.

But the GIRY's historical analysis reveals that finding a solution to the problem may not be as easy as the investment savings industry would have us believe. The most common solution offered to combat inflation is putting money into the stock market.

This makes sense. Shares are known as real assets because, overall, one could reasonably expect a company's revenue, and thus profits and dividends, to rise with inflation over the long term.

But the key variable here is "the long term" - it can be longer than you think. If you had bought a portfolio of global equities on January 31, 2000, your savings today would be about 60 per cent behind inflation.

As one reader pointed out online, that poor performance is partly due to the weakness of the US dollar.

Nevertheless, in US dollar terms, too, world stock market returns have lagged US inflation by about 1 per cent a year over that period.

If that is a shock it could be worse. According to the GIRY database Italian share investors who bought in at the worst possible time in the past 112 years had to wait for 74 years for their share portfolio to catch up with inflation. Even with the benefit of a relaxed work ethic, a Mediterranean lifestyle and early retirement, not too many Italian 55-year-olds who invested then would have lived to see their shares achieve a real return.

So is there a reliable solution to the inflation problem, and if there is, what is it? This year's GIRY looks at the facts over 112 years in 21 countries without the biases that frequently conflict those who sell shares, bonds and alternative assets.

First up, the professors caution that we must differentiate between an objective of beating inflation versus one of hedging inflation. An inflation-beating strategy is one that has achieved a return above inflation.

But this good performance might just be a reward for risk and in reality may have little to do with inflation. Conversely, an asset that hedges inflation is one that goes up in price with inflation. However, its long-term performance may be low.

The professors argue that shares are a good example of an inflation-beating strategy because over the long term shares in their sample have achieved a real return; that is, above inflation of 5.4 per cent a year.

Shares have beaten inflation not because they rise when inflation rises but mainly because they are risky and thus deserve a high return. In fact, the professors' research confirms what many other academics have shown - when inflation rises sharply shares do less well in real terms than when inflation is low and stable.

The professors conclude that if you want an asset that can be relied upon to go up when inflation rises - that is, an inflation-hedging asset - then inflation indexed bonds (IIBs) are the asset class to own. IIBs hedge inflation, but because inflation is the thing that everybody worries about IIBs are popular and are thus priced to give a low return.

In New Zealand IIBs issued by the Government yield just inflation plus 1.15 per cent. Not very exciting. But investors abroad would love that yield. American and British inflation-indexed government bonds are often priced at negative real yields.

Looking at the performance of shares, bonds and inflation more closely, the GIRY concludes that "shares are at best a partial hedge against inflation" and "their returns tend to be higher during inflation but not by a large enough margin to ensure that the returns after inflation completely offset the inflation".

But while shares don't completely hedge inflation, they are a much better alternative than conventional government bonds. Government bonds like inflation even less than shares, but this can be a strength as well as a weakness.

The research shows that the prime attraction of bonds is that they perform well when "the market" worries about deflation. The key here, though, is credit quality.

Bonds issued by many companies might default in a period of prolonged deflation. Lots of banks went bust in the 1930s when the United States had a severe deflation. I believe even some New Zealand banks had to be bailed out in the 1800s when deflationary conditions affected the farming sector and bad debts eroded their capital.

The moral of the story is that bonds protect against deflation but your bond portfolio should be focused on the likes of governments, SOEs and city councils.

The biggest mistake financial advisers who recommended finance company debentures made was to buy low-quality bonds as part of their clients' bond portfolios because, when things get tough, low-quality bonds change their spots and start acting like shares, and thus offer no diversification benefits.

An individual with a portfolio of shares and finance company debentures may on paper have had a portfolio of bonds and shares but in reality they owned only risky assets.

The GIRY also looked at the performance of other popular asset classes in varying inflationary and deflationary environments.

There is a bit of good news here for residential property owners.

The professors cite a study that looks at residential property price-only returns from 1900 to 2010 for Australia, the US, Britain and three European countries. History records that returns from residential property excluding rents in most countries have kept up with inflation and in Australia have exceeded inflation by 2 per cent a year.

In summary the GIRY says investors using shares as a hedge against inflation should realise their capacity to do so is limited, as high inflation harms their real value.

Given this, and the volatility of shares, share portfolios should be diversified globally so foreign currency exposure can work with foreign equity exposure to provide a hedge against local inflation.

The big attraction of bonds is that they are the only asset class that can reliably hedge against deflation.

So the 2011 GIRY leads us back to the standard solution that should be adopted by all investors eyeing retirement: build a widely diversified portfolio and make sure you own bonds issued by genuinely low-risk institutions that will survive a full-blown depression.

Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.