Received wisdom would be to rank possible investments in order of their volatility – the amount they oscillate in value – as a proxy for their safety. On this basis cash is safest, followed by bonds, property and then, at the riskier end, equities. It follows that you would expect to get a higher return for the most risky assets and the lowest return for the safest. This has been shown to be the case over very long time periods, but over shorter ones often it is not.
Let us use a simple example to show why a share price might go up or down. Imagine that I run a firm making sunglasses. I sell shares in my company to a number of investors. How do they decide what price to pay for that share? They would look at how many pairs of sunglasses I am selling and how many I am likely to sell in the future. They would work out a price based on my earnings. This is a valuation or, in this instance, a price-to-earnings ratio. Let us then imagine that weather forecasters predict that it will be a hot summer. My shareholders are excited and expect me to sell more sunglasses, and other investors are likely to pay a higher price for each share. My company just got more expensive because of what is expected to happen.
Cheaper shares often offer the best returns, but this is difficult to put into practice because low prices often reflect pessimistic expectations
There is plenty of evidence to support the claim that it isn't what you buy but the price you pay that is the key to future returns. The cheaper shares often offer the best future returns. This is not rocket science, but it is often difficult to put into practice, because low prices often reflect pessimistic expectations.
This can help to explain how asset returns do not always follow the pattern that the lowest risk gives the most dependable return. Let us look at government bonds: you can currently lend your money to the government by investing in a bond for 10 years. This will give you a return of less than 2 per cent a year – lower than the government's own target rate of inflation, suggesting that you will be able to buy less with the proceeds of your investment in 10 years' time than you can today. Government bonds seem expensive.
Charities often hold bonds in their investment portfolios as safe assets, which they combine with riskier assets such as equities. This worries me. An increase in interest rates to normal levels – those typical at current levels of growth and inflation – would correspond to a 15 per cent fall in the 10-year government bond price. On valuation grounds, you would wish to hold bonds only if you believe that deflation is a threat and that interest rates will stay low.
Theory tells us that the least volatile investments should provide the most dependable returns, but this is not always the case, and charities should be wary of bond markets that might be ready for a fall.
Kate Rogers is client director at Cazenove Charities