A Couple of Pieces of Advice from the Mainstream

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

Although I have often swam against the mainstream and although such an approach to investing, more often than not, has worked for me, it is not to say that there are no lessons a contrarian can learn from the mainstream, particularly when it is the wisdom of institutional investors we are talking about.

The most important question for ordinary investors is the question of returns, or rather investors’ expectations of return. It is an easily quantifiable goal for any portfolio. The target returns usually operated with are six percent, eight percent or even 10%. But there are multiple levels that ordinary investors often ignore and their brokers often prefer not to discuss in detail.

Namely, when an investor throws a number such as having a goal for his or her portfolio to return six percent over a certain time period, the industry classifies it as something called “nominal return;” that is, the return before taxes and inflation. In contrast, what the investor usually means is the money that he or she would like to pocket at the end of a predetermined investment horizon.

The advice of institutional money managers is for ordinary investors to put their realistic goggles on and focus on achieving a target return, but after taxes and inflation. To put things into perspective, let us assume you had to pick between a 10% return at five-percent inflation and an eight-percent return on two-percent inflation. Which rate of return would you pick for your portfolio? Most investors would likely go for the 10% return, thinking the impact of higher inflation cannot be that great when the gross return is high. Yet, it can. An experienced and sophisticated investor will always go for an eight-percent return on inflation of two percent, because it means his or her net return would be six percent. In the case of the first option, the net return would be five percent and it would also imply taking on more risk to achieve the higher gross return rate.

Furthermore, the mainstream appears to have developed a renewed taste for equities. About a decade ago, if an institutional asset manager had a pension plan for a client, perhaps the only strategy up for discussion would involve bonds or bond benchmarks, preferably focusing on government bonds. Today, however, exposures to bond portfolios have been cut by about a half.

The reason for such a change in sentiment is simple. If the trustees of a pension plan have been tasked by the plan’s board of directors to achieve a return of four or five percent after inflation, then proposing a government bond portfolio makes no sense. Government bond portfolios currently earn barely three percent returns, so obviously bond strategies alone cannot ensure that longer-term return targets would be achieved.

Ordinary and institutional investors have a difficult decision to make. While government bonds offer stable, albeit low, returns in the short term, they cannot take your portfolio where you want it to go in the longer term. What is the alternative? Institutional investors say that it may be time to switch focus on equities, or at least to increase exposure to equities within existing portfolios.

To put things into perspective again, historical market data show that, over the long term, U.S. equities have generated an aggregate gross return of nine percent, which, adjusted for historic inflation of two percent, left investors with a net return of about seven percent, depending on the investment time horizon. Better yet, even if inflation is adjusted upward, as many economists predict is likely in the longer term, equities may still offer better long-term returns than bonds.