I single it out because outsmarting the smarts with simple thinking is very No Monkey Business. In fact, the same data has regularly featured in No Monkey Business posts since 2006 (about a year behind Paulson) as an obvious parallel with the Nationwide deflated index of UK average house prices which I regularly monitored on the No Monkey Business blog from about 2002. Just don’t ask me where my $4b is.

What drew me to the study of the trend and deviations from trend in real house prices was that it was itself a parallel application of an important insight about equity returns: historical time series for ‘real total returns’ (ie cumulative indexed performance with income reinvested, deflated by a consumer price index) contain valuable predictive information for investors, and more so than conventional valuation measures like price/earnings multiples and dividend yields. This was one of the big but simple ideas set out in my book in 2002. Since 1999 it has been the basis of horizon-specific probabilistic return projections in a model we now use to manage Defined Outcome portfolios.  

Such an apparently naive solution to a complex problem is deeply offensive to most investment professionals as it implies redundancy for much of their industry. I naturally therefore warmed to the naivete of the Sunday Times account, as typified by this extract.

'Everybody said home prices never had declined on a nationwide basis except during the Great Depression,” Paulson later recalled. He sent Pellegrini scurrying back to his cubicle to determine how overheated the property market was.Tracking interest rates over the decades, Pellegrini concluded that they had little impact on house prices. But as he reviewed academic and government literature and figures, Pellegrini grew frustrated. He couldn’t quantify how excessive housing prices were or show when a bubble might have started. He couldn’t even prove the price surge was distinct from historic moves.Grasping for new ideas, Pellegrini added a “trend line” to the housing data; this illustrated how much prices had surged lately. That’s when Pellegrini took a step back to view things over a longer period, ordering up data on home prices all the way back to 1975. Suddenly, the answer was as plain as the paper in front of him: housing prices had climbed a puny 1.4% annually between 1975 and 2000 after inflation was taken into consideration. But they had soared by more than 7% a year in the following five years, until 2005. The upshot: US home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop was likely to be brutal. Pellegrini sat upright, staring at his trend line, amazed at how simple and clear it was.The next morning, he raced in to show Paulson. “This is unbelievable,” said Paulson, unable to take his eyes off the chart. “This is our bubble. Now we can prove it.” Pellegrini just grinned, unable to mask his pride.'

The standard source material for real house prices, deflated by general inflation as measured by the CPI, was the S&P Case-Shiller Index. Pellegrini refers to data going back to 1975 but there is in fact earlier data which I came across a little later in the form of index creator Professor Robert Shiller’s submission to a Congressional commitee. In September 2006 I posted an item on the No Monkey Business blog called US house prices: you thought we had a problem which included a chart of over one century of real prices for single-family homes.

It was important that the data be real. Real prices are perhaps better decribed as relative house prices, because they measure prices relative to general price inflation. But even real price series were rarely publicised because of people’s obsession with changes in the price level, treating house price inflation as the key information rather than the level of relative prices itself. This was a widespread problem in the US just as it was in the UK. I still berate newspaper editors for repeating this error.

As I pointed out in my article, fitting a regression trend to the long time series data was not helpful because there were several distinct phases of price behaviour, including just two since the end of WWII, up to and after about 2000: no real growth followed by a growth explosion. In my article, I contrasted the absence of any overall trend in US real house prices prior to 2000 with the trend in post-war real prices in the UK, which has been fairly persistent at about 2% per annum, in line with growth in personal incomes.  The 0% trend in the US for some 50 years means that relative to personal incomes US housing had become progressively more affordable. I agreed with Prof Shiller’s interpretation that this was due to easy access to new development land, an endowment we clearly do not enjoy in our planning-constrained small island.

More important, the only plausible explanation for the change in price dynamics after 2000 was the change in credit availability. The fact that people wanted to believe in endless rapid growth, a new twist to the American dream, was a necesssary condition but it also required bankers and mortgage investors to throw caution to the wind or the boom would have simply run out of fuel. And it was the massive stock of derivatives created on the back of securitised mortgages, two symptoms of the credit-induced madness that overtook the housing market, that gave Paulson & Co the instruments, in the form of credit default swaps (insurance contracts that would pay out if the underlying securities fell in price), which had the inherent leverage to turn £147m into $20b.  That was convenient but it was also smart and gutsy.

Is he right?

In this increasingly popular view, the actions by governments to pump money into the stalling financial system are seen as giving stocks a reprieve before they reached the sort of valuation levels that properly discounted the post-credit crunch realities facing economies and businesses. Hence the anxiety now as the patient looks to be coming off life support. 

John Authers’ preferred measures of value, using replacement value of assets (Tobins q) and a trailing 10-year average of earnings, supports the story that US equity investors, like the banks, got lucky and were bailed out before reality had sunk in to share prices.

I don’t think we can agree with that. Our own measure of value suggests that the last move down in the S&P at the start of 2009 took the market to an extreme level with only a few historical precedents in any major equity markets, all equally important as long-term buying opportunities.

Whilst we attach a great deal of importance to our measure of value as a basis for forecasting long holding-period return probabilities that can be used in asset allocation, it still does not mean there is a negligeable chance that the S&P will fall through the earlier low. Though it would be unprecedented for the US market, it happened in the UK in 1974 and in Japan in the 90s and again in 2003. What can happen in one place can happen in another.

There are also several historical examples where extremely high predicted value has persisted for a decade or more, Japan being one but Continental Europe in the late 70s and early 80s is a less familiar one, being disguised at the time by high inflation.

Though the FT piece was about the market most likely to influence the general direction of global equities, it is worth noting more parochially that on our measure the FTSE All Share Index is the least undervalued of all the major markets and did indeed recover well before reaching a historically exceptional valuation.

Lateral thinking about equity valuation

We agree with John Authers that Tobin’s q and trailing 10-year earnings will dampen the effects of extreme cyclicality in current fundamental inputs to valuation, particularly reported earnings. As an accompanying chart in his column showed, reported earnings in real terms reached a low point last seen in the 1930s although clearly this is not what has happened to ‘earnings power’ for American business.  The q ratio dampens variance simply because replacement value of assets is very stable, so the significant information comes from price change. Averaging earnings over several years will also dampen the valuation variance but is transparently arbitrary and may also leave price variance as the important information. These may therefore be better than conventional price/earnings ratios when earnings are disturbed but they are still not rigorous indicators of extreme valuation, high or low.

As market historians, Chris Drew and I have since the late 1990s adopted a lateral approach to equity market valuation, formalised in a return-generating model called Lambda. We ignore fundamental inputs, because of the measurement problems, in favour of tracking the path of achieved real total returns from each market and comparing it with its own long-term trend, using ’best fit’ regressions. The model has not been invalidated by subsequent return behaviour and has indeed handled several episodes of extreme valuation very well.

On this measure, the recent low for the S&P was as low as the previous extremes of the early 30s and 40s as well as 1974 which was revisited (in real but not money terms) in 1982.

Fig 1 shows the S&P continuously-compounded logarithmic returns with gross dividends reinvested and deflated by the CPI from 1925, as an index. The whole-history regression trend (colour) is 6.8% pa but the hindsight-free trend using data up to each point in the series (colour) was above or below this as a function of the particular period. In my book I showed a Wilshire series for US equities for nearly two centuries that revealed a similar trend in both centuries, in spite of massive contextual differences. Data for other major equity markets also suggests about 5-7% pa as a trend, with much narrower dispersion of the differences than economic context and culture might suggest. Global evidence suggests regression trends are not just a statistical accident but an economically sustainable quantity that is a core element of the equity return process. We believe there are strong theoretical underpinnings for this, based on both economics and risk aversion.

Fig 1 Trend and deviations from trend in real equity returns: S&P 500

This idea of sustainable real equity returns over long holding periods is really important. It conflates into a single measure two crucial influences on returns: i) fundamentals (like earnings and dividends) and ii) investor behaviour changes (like risk aversion, sentiment and momentum following). Historically, even over long holding periods, the second set of uncertainty sources has usually dominated the first, which makes the traditional focus on fundamental inputs look odd. If jointly the two sources of uncertainty lead to bounded deviations from trend, as a further core element of the return process, we do not need to disaggregate them to model either returns or risk.

Fig 2 expresses the level of the real total returns index as a ratio of its own trend, or detrended, which we call the Market Value Ratio. We use this as a basis for adjusting upwards or downwards the mean expected returns extrapolated naively from the trend alone. Low price denotes high value and high future returns and vice versa. By making some assumption (itself based on historical analysis) of the time-dependent reversion to trend, we can estimate real return probabilities for every holding period as often as we gather new historical return data. The actual frequency is monthly.

Fig 2 Market Value Ratio: S&P 500

What can we do with value?

Fig 2 makes the point of this post that the S&P low in March last year was extreme. This observation was sufficient to justify exceptionally high expected future returns, provided long holding periods could be assumed. For investors with naturally long horizons, this amounts to a lot. It is why we added with confidence to clients’ total equity exposures up to the low point, while others were selling, and reduced them either side of this recent year end. See Is your manager doing a good job? (22nd January). 

Observing extremely low value by March 2009 may even have been enough to warrant assigning a very low probability to further downside risk over short horizons, which would also amount to a lot if, it could be relied on.  We do not believe it can. We prefer to treat short holding-period returns as a ‘random walk’. That was not the basis of our decision to buy.

An aside for more numerate readers: short-run returns, whether deflated or not, also have the highly inconvenient statistical characteristic of fat tails, or extreme outliers that would not be predicted if assuming a normal distribution. Long holding-period real returns, on the other hand, appear to be normally distributed. 

We sympathise with John Authers who is obliged (as a good journalist rather than a good story teller) to remind us that even a ’true’ valuation of the market tells us very little about the chance of the market falling or rising or staying the same over the next few years. This might read as ’sitting on the fence’ but it is more insightful to see that good valuation measures simply have restricted uses.

For us, as financial planners and even as portfolio managers, using them to project long holding-period real outcomes is actually more important than using them to try to time markets. Imagine yourself in 20 or 30 years time looking back and deciding you got the outcomes you wanted and planned for. Is it most likely you will credit the many market timing decisions that made up the path your money took or rather making the right long term decisions? We have no doubt and we don’t think our clients do either.

(Please note this is only open to Olswang Partners)

In this workshop, the Olswang Partners will gain a better understanding of pensions;

• As part of retirement planning
• Which is itself part of lifetime risk management and capital efficiency planning
• Covering all assets, all of your life
• Which can promise better outcomes for lifetime consumption and bequests
• And ensures you do not make mistakes in the snake pit of HMG’s ‘simplified pensions’ regime

Key factors to focus on when accumulating wealth

• Embrace capital market risk but avoid inflation risk
• Keep costs as low as possible
• Pay most for the things that most impact outcomes
• Make the best use of pension and other ‘wrappers’ as holding vehicles to maximise flexibility and expected after-tax outcomes
• Well before you start decumulation, plan how you intend to convert capital to an income stream so you really do ‘derisk’ instead of just swapping risks.

What will the partners get from this session?

1. Early warning of suboptimal actions or omissions
2. Insights into what they are paying and getting from our industry
3. Enjoyment of engaging in a vital dimension of their lives, without being too serious!
4. A sense of what it would be like to be advised by us

Not that many people have any idea what the trend of real house prices is, relative to general inflation. Or how much investment in both maintenance and improvements needed to be made just to keep the ‘average’ house comparable over decades of increasing expectations about the quality of housing.

Most people are more likely to quote what a pittance they paid back in the year dot, forgetting even that back then it was probably a bank that effectively owned most of their equity. So their picture of the property market is something like the chart below, which is for the Nationwide price index for the ‘average’ UK house. It does reflect the improvement in the quality of the housing stock, otherwise the growth curve would be even higher, but it does not allow for general inflation.

This is not, of course, how we look at any asset prices at No Monkey Business. We are interested in real returns, after inflation.  We are also interested in what trends in real asset prices over very long periods can tell us about economic sustainability and its corrollary, bubbles.

We have many times shown the chart below which applies the RPI to the index above and then also ‘detrends’ the index to show the cycles around the sustainable growth (which since 1957 has been 2.8% pa).

This is the one that shows the extent of the overvaluation before the credit cruch finally hit and also shows for how long prices defied gravity – something unusual we can put down to binge banking. The bounce at the end has probably been extended slightly further in October and November.

Since the trend itself is broadly in line with long-term growth in real personal incomes, the economy as a whole and also the capital returns from equities, it is probably a fairly accurate measure of economic sustainability. So we can reasonably deduce that UK land and homes are generally (with regional variations) close to ‘fair’ or ‘normal’ value. (Note that this analysis ignores the economic rent from the property, even though about 10% of the housing stock is rented not owner-occupied. It treats the economic rent as part of personal consumption and therefore equivalent to paying rent.)

Apart from the important information that anyone buying today is not being carried away by a bubble, this does not tell us much about what will happen to real house prices in the next few years. This is because we do not know

• how much pressure real personal incomes will come under
• where and when unemployment will peak
• how much credit supply will shrink or improve
• what will happen to the supply of new homes.

Short memory, long memory

Even though the recovery in house prices and the pick-up in activity in a number of local markets suggests the return of ‘business as usual’, it is possible that some fundamental changes are occurring to public perceptions about housing investment in lifetime financial management.

It would not be surprising if these changes reflect age and experience and so depend on whether participants in the market are principally influenced by short or long memory. Short memory tends to be dominated by the cycle and long by the combined effect of the trend and gearing.

Short memory has been scarred and may turn into a quite different long memory for several generations, consisting of the excluded young and over-extended young who were buyers within the last ten years. If employment prospects deteriorate further for this group, and money becomes expensive in real terms, they are unlikely to heed their parents’ advice that property is the best route to wealth creation, even if they can access the credit necessary to start the process. It is not a foregone conclusion in the UK that this change will occur but in the US, where the housing mania was a relatively new phenomenum and joblessness is a more present threat, the dream is well and truly dead.

Long memory has several bullish strands that are much more resistant to change, each of which nonetheless is open to question.

1. The combined effect of the long-term house price trend and gearing
2. Deep memory of housing as an inflation hedge
3. Housing equity as a superior alternative to conventional pensions
4. Our homes as an inheritable estate.

1. The payoffs to gearing

As we have already noted, many people’s perception of their own ‘returns’ from home ownership may well be clouded by the fact that their entry points were below trend, something that our second chart suggests may apply to any purchases in the 1990s, for instance. Clearly, without the benefit of  real prices being below trend when each new investment is made, the trend itself will not make anyone rich without gearing and gearing will not make anyone rich unless the cost of money is low relative to the asset returns themselves.

There is some neatness to the fact that in the 1990s, when nominal interest rates were low but real rates were historically high, moving from below to above trend offset the drag on real wealth of owning a mortgaged asset. Prior to the 1990s, when nominal interest rates were much higher, real interest rates were persistently low and turned a high-risk strategy for several generations into an ‘easy win’.

Popular versions of the property bias treat rent as ‘money down the drain’. Are we ignoring this? Yes, deliberately. The buying versus renting decision, when capital resources are insufficient to finance either the acquisition of a freehold without borrowing or an equivelent stock of financial assets, boils down to a choice between renting money and renting property. The outcomes of that choice depend on the two factors we are addressing here: asset returns and the cost of money.

If we are right that what the future generally now holds is mediocre real growth and high real borrowing costs, playing out against a background of perceived higher economic risk, the collective memory of an easy win may start to feel more like a lucky break.

2. Housing as an inflation hedge

The impact of gearing, and its dependence on the asset return trend relative to the real cost of borrowings, should also dominate the second strand: housing as an inflation hedge. However, ungeared property is directly comparable with other assets that have inflation hedge characteristics based on their own long-term real return trends, notably equities. Indeed, an economist might well argue that there is little reason to select between them on return grounds (other than as a function of unusual starting conditions) and that factors to do with personal welfare or ‘utility’ should dominate individual choice.

3. Housing as a pension

Long-term bulls also repeat the mantra that housing is a better pension than financial assets. The typical middle-income British family has certainly put its money where its mouth is. We know about the economic research that suggests a long-term savings gap and we know about survey evidence that most households see debt repayment as a more pressing priority than pension savings. Put the two together and you would probably see that the cash flows represented by the gradual purchase of housing equity from the bank (ie repayments rather than debt service) substitute for the savings they should be making to meet income replacement expectations in retirement.

Because they believe that gearing pays off, they are acting entirely rationally. Had they made a more informed judgement of risk-adjusted payoffs, allowing better for the risks to the household of gearing, they might have chosen differently. But what is also clear is that, believing what they did, they would never have been able to take as much risk from an ungeared financial asset portfolio, in or out of a pension fund.  Nor would they have found an adviser willing to recomend such a high level of risk for a financial asset portfolio, since advisers (and product companies) were in this department much less smart than the average household. In fact, the typical investment recommendation was the same as the one used to fund debt repayment when an endowment was preferred: a balanced, managed fund with real assets diluted by nominal assets like gilts. That hardly suggests joined-up thinking about balance sheet strategy.

In retirement too there are many reasons to prefer to live off the CGT-free proceeds of a house sale than pension income trapped by GAD rates and taxed at 82% on the last survivor. The last one is very recent and was not foreseeable except that people are generally sceptical about the direction of pension taxation.

The only thing wrong with the ‘house as pension’ idea is that people seem to be overlooking the exit strategy. If we are right about housing filling the savings gap, households will need to consume a big chunk of their ‘house as pension’ and if they cannot do so via debt it will have to be via sale of equity. Where, then, are the forecasts of this or its effects on house prices?

If households are not yet being realistic about the need to consume housing capital, will waking up to the reality also encourage a shift in popular perceptions and long memory? Ironically, the main impact is on their heirs, where we think short memory effects are anyway much more bearish about property. This is because home owners who understimate their capital consumption needs correspondingly overestimate their bequests.

4. Housing as a bequest

I believe the bequest motive was always one of the welfare benefits that drove middle-income families to make either one or both of two ’sacrifices’ for the sake of their children: education and their home as an inheritance.

For early acquirers, the bequest element of a freehold, as in the cost of the property accounted for (in present value terms) by the years beyond their own life expectatncy, was in fact low or negligeable because of high nominal interest (or discount) rates. With lower rates over the last decade, however, there has been a real cost to the bequest element, of between 10 and 20% of the market value. The later people invest, the greater the capital inefficiency inherent in a freehold provided only that their bequest utility is weaker than their consumption utility. If they have no bequest utility, such as because they have no children, home equity is always going to be irrational if it constrains lifetime spending.

For the present generation of first-time buyers, starting out in their mid or late 30s, the conflict between trying to satisfy occupancy benefits and building up an inheritance for children they may or may not have, when the two are bundled, is itself a factor likely to influence perceptions. The problem is of course resolved by being able to unbundle the two, so they only have to meet the capital requirement for lifetime ocupancy in the form of a lease of, say, 50 years.  The structural inefficiencies of the inflexible UK housing market are one of the attributes overlooked by people who think property is better than financial assets.

Conclusions

When I first started measuring real house prices over a decade ago, the trend was 2%, not nearly 3%. If real prices now stagnate or fall, the regression trend will gradually work its way down. But behind the dry statistical measure I suspect will be a genuine shift in collective perceptions about the nature and payoffs of a massive leveraged bet on bricks and mortar. I see this as a shift to something still potentially good but also much more realistic and dependent on individual situtations instead of general to all people.

What would prove this wrong? If, within say the next five or more years (before long memory can shift), we both avoid a second leg of this bear market and enjoy a new cyclical surge upwards in real prices.  Be in no doubt that if this happens it will be nothing to do with supply and demand for housing and everything to do with money and credit. Money always explains the booms and busts better than fundamental changes at the margin of the total housing stock.

In today’s climate, a new boom is a pretty brave forecast. It is also a fundamentally bearish one, suggesting we have learned nothing from the credit crunch and are willing to risk an even bigger collapse in household and national solvency in the future. We would probably not have long to wait.

Finally, if reading this you realise I have introduced you to some aspects of home ownership you had not appreciated before, you might want to consider whether this is a vacuum in which bad ideas have flourished by never being exposed to proper review. If I compare the level and scope of analysis of both property economics and behavioural biases to housing decision making today with my experience of the same in financial assets, it is vastly more primitive now than investment was when I started my career in the late 1960s. After the shock to home owners in this global bear market, I would like to think vacuity will be one of the main casualties.

Conventional bonds or fixed income investments are one of the key building blocks of the investment portfolios of private clients, trusts and institutions.

• Allocations to bonds are typically the main means by which managers and product packagers customise a diversified or ‘balanced’ portfolio so it matches some definition of client risk tolerance
• Bond holdings are used by personal pension managers in the crude ‘lifestyle’ feature of gradual risk reduction in the years leading up to retirement
• Bond yields are used in modern accounting as the discount rate for measuring the present value of long-term liabilities such as final-salary pension promises, encouraging their use as a ‘matching’ asset
• Bonds are widely used to maximise income where this is a priority for investors.

Each of these conventional uses of bonds is intellectually flawed.

Whether intuitive or well-informed, recognition of this is actually implied by many private investors’ affinity with mortgage debt (they love repaying nominal debt with depreciated currency) and aversion to fixed-income annuities (they hate receiving a pension in depreciated currency). However, when it comes to investment, in the face of such entrenched portfolio practice, they need logical argument to resist the industry’s recommended use of bonds.

The counter arguments rest to some extent on the same theories we embrace when seeking to integrate investment management and goal planning, such as maximising some goal-specific ‘utility’ which is defined in terms of purchasing power. Stripped of technical language, this means a portfolio is organised to deliver specific outcomes the client defines and which are expressed in real or inflation-adjusted terms. Preferences and trade offs are made at the planning stage by selecting between alternative sets of outcomes.

Being based on established theories, the arguments have been discussed and reviewed in a number of academic papers. But they also stand up to simple logical tests and to the lessons of historical evidence. They are not complex and, though near enough complete, what follows is not a long explanation.

Bonds as a bet
We have a general preference for distinguishing investments as bets. The industry avoids this language either because they think it creates the wrong impression of them or because they do not want investors to be totally clear. So what is the bond bet?

Bonds pay a fixed income, fixed in money terms, for a fixed period and then return your original capital, also in money terms. What you risk is that the borrower cannot pay the interest or repay the capital. The default probability is evidenced and manageable. A bigger risk, which cannot be diversified, is that the nominal cash flows fail to provide a satisfactory return once inflation is taken into account.

The public market in bonds plays an important collective role in determining the best guess as to what future inflation will be, so that nominal yields always take into account inflation expectations. Borrowers will try to set the interest rate and governments are the borrowers who can best manipulate rates (and boy they try). But bond investors do not have to lend, or lend long, so they ultimately set long-dated rates.

How good or bad the bond investment crowd’s inflation guesses prove to be is what determines the outcome of any long holding-period investment in bonds. The record is poor. Cumulative real returns have turned out to be quite strongly positive or negative as often as they have ‘normal’. For investors concerned about long-term purchasing power, bonds come with very large ‘outcome uncertainty’ or risk. Why they might want to take this gamble when they can easily avoid it is a question every investor should ask themselves.

Bonds in a portfolio of bets
Historically, bonds were not added to equities to diversify risks. Rather, as theories about the true risk of diversified portfolios of company shares versus the risk of individual share speculation took hold in the first part of the last century, equities were added to bonds.

Early portfolio theory did not need to think in real terms to advance combinations of bonds and equities as generating superior risk-adjusted returns. In the best-read investment book of all time, The Intelligent Investor, Benjamin Graham explained as early as 1950 the principle of combining two assets that moved over most short periods in opposite directions (negative correlation). It proved not to be the case, other than in brief intervals, but as long as correlations were much lower than 1 there would be a benefit to normally risk-averse investors from holding both.

This assumes that the right measure of risk to weigh against the cost of slightly lower return is the volatility of the return path over short periods. In other words, we will accept lower wealth outcomes if we can take away some of the anxiety provoked by the bumpy ride. As a description of typical investor utility, or preferences for making trade offs, this works fine as long as the bumpiness of the ride is also the same as, or similar to, the uncertainty about the outcome. In a world where everyone focuses on nominal returns from investment, not adjusted for inflation, the two are near enough the same. But in a world where many investors are not fooled by money illusion and focus on the purchasing power of future wealth levels, real outcomes adjusted for inflation matter as much as, or more than, the bumpiness of the path and, because of the nature of the inflation process, the two degrees of risk are not at all the same.

In the chart below, we have approximated the position of the main financial assets used in conventional portfolios on two axes:

• outcome uncertainty (the range of possible real outcomes over horizons of 15 or more years) and
• path volatility (satisfied by monthly standard deviation of returns)

Reflecting the fuzzy and time-varying nature of the observations, they are shown as areas rather than points. Bonds are shown here as having outcome risk that is not a lot less than equities. The historical evidence of bond real returns is drawn from the UK rather than some other countries whose bonds were devastated by hyperinflation (otherwise they would be even riskier than equities).

In real outcome terms, the most certain asset is an index linked gilt (ILG) matched to the term of the desired outcome (which we elaborate on below when discussing a better approach).

The fact that an ILG secures all inflation risk yet is still quite volatile in the short term (ie is plotted a long way to the right) illustrates perfectly the principle that investors need to be clear about priorities, either for all their money or for particular goals. There is no perfect asset that has a smooth return path and delivers certain real outcomes at distant horizons, so a choice has to be made as to which benefit they most value.

How inflation affects risk
How does inflation risk drive a wedge between path volatility and wealth outcome uncertainty? It is because of the nature of the inflation process.

The price level with fiat money (paper currencies issued by governments) is not subject to self-equilibrating forces. There is no ‘natural’ level. The cumulative change in the price level over long periods is therefore a function of changes in the rate of change in the price level, or changes in inflation. This, though not well understood, is generally thought to be best characterised by ‘regime change’. This means it is well-behaved for long periods (next year’s inflation rate will be close to last year’s) but then encounters shocks as a result of which it first becomes unstable and then moves to a new level of rate of change at which it becomes stable again. Subsequent shocks may restore it to earlier or even different stable levels.

These shocks are not predictable. This explanation accounts for the breakdown in the wisdom of crowds as a basis for reasonably accurate forecasts of future inflation.

Investors need not have experienced the shock of living on fixed incomes in the 1970s to accept this humbling inadequacy. Markets then failed for nearly a decade to build in the moderation of inflation into their estimates of future inflation. As if that were not sufficient proof, consider how badly anticipated has been the inflation acceleration around the world in the last few years.

There is no shortage of less-than humbled forecasters willing to bet (if only with other people’s money) on recession leading to slower inflation or even deflation. This ignores the scope for governments, with the active endorsement of voters, to print money to ward off debt deflation.

Correlation uncertainty and the portfolio bet
Portfolio theory needs expected returns and standard deviation, equivalent to path volatility, but also needs an estimate of correlations between them. As noted, correlations change dramatically over time. This process is also poorly understood and not that widely researched in academia. However, the historical evidence points to the possibility that it is unexpected inflation, or estimation errors, that may mostly account for the big changes in correlations. It is highly inconvenient for portfolio theory if the errors in estimating the key variables are not independent.

These findings support our case for building portfolios on the basis of real wealth outcomes rather than short-period returns and risks.

We do not need to exclude bonds as a prior. Allowing them to compete in a portfolio optimisation process, whereby an efficient trade-off is sought between risk and return, bonds will not win an allocation if realistic holding-period real returns and risk (largely inflation risk) are used as inputs.

Bond income: the distribution fallacy
Bond investment also involves a transfer of potential consumption from the future to the present whenever the income component which represents the market’s guess of future inflation is spent or distributed. It cannot be both spent and added to the nominal capital to support future spending.

In this case, the full amount of the inflation rate, rather than the error in estimating it, is what reduces future wealth outcomes.

The inflation guess is usually the largest component of the yield (historically, say 2-10% versus a ‘real yield’ component of 1-3%).

This ‘consumption time shift’ may be a deliberate preference, it may be unrecognised or even a fudge between the two. A level annuity to meet retirement spending, for instance, is probably seen by most people as a declining income in real terms. In this case, the rate of decline is left to the mercy of the gods rather than managed.

When recognised, it may be the investor’s preference but it may also be the agent’s preference, as it will take a long time for the customer to discover that the solution is the wrong one. The industry has been cute about its use of bonds to maximise current income as well as to minimise the use of cash (on which it is harder to take fees) as a means of diluting risky exposures.

The consumption shift is also a source of potential conflict within trusts. As well as leading to unmanaged risk of decline in real incomes from the trust, holding trust capital in bonds can favour a life tenant at the expense of other beneficiaries’ purchasing power in a way the settlor had not intended. In the nature of trustee liabilities, this should never be a fudge, let alone unrecognised.

The tax inefficiency of bonds
Finally, governments collude in your ignorance of these simple truths about bonds by taxing the inflation compensation component in exactly the same way as if they were real. Real yields need to be higher to earn any economic rent from capital after tax. In other words, the bet on the market’s inflation guess has to be right even to stand still in real terms.

Governments have nonetheless made index-linked investments available that are taxed less heavily. Because the capital protection comes as a tax-free uplift to the sum at redemption, only the bond interest suffers tax and this is running at under 2% versus nearly 5%. A difference of 1.2% for a 40% tax payer is a hefty price to pay for the inflation bet. HMRC may be indifferent to which form of inflation protection we choose but we should not be.

Better ways to manage risk
Risk control, when purchasing power matters, is better performed differently. There are far better assets with uncertain real payoffs than bonds and these can be customised to personal risk tolerance by diluting them with holdings of assets that have near certain real outcomes.

Using dilution instead of relying on diversification between more risky assets creates a far wider spectrum of possible outcomes with which to satisfy different investor preferences and reduces the number of assumption errors which might taint the projected outcomes.

Index linked gilts, matched to the maturity (or duration) of the goal are the most certain. In a portfolio construction process that maximises some investor utility, the appropriate index linked gilt yield provides the risk free rate and risk aversion describes the ‘indifference’ between that rate and some uncertain (but higher) rate.

In our approach, risk aversion is not derived from questions about investment but by preferences between model outputs in the form of the range of possible outcomes. Outcomes are usually expressed in the terms relevant to the investor and understood by them, such as a sustainable rate of spending in real pounds (eg if drawing down to meet lifetime spending). In this approach, the cost of avoiding risk, both capital market and inflation risk, is explicit, as a reduction in the range of potential outcomes as well as a narrowing of the range.

Rolling over cash (or very short-dated bonds) is less certain but much less risky than long-dated bonds. With cash or short bonds, you get to reinvest the capital coming back to you at the market’s new estimate of inflation. With long bonds, only the interest gets reinvested with the benefit of new inflation estimates, assuming the interest is not being spent. Hence the bet on the estimate is much greater. You might be on the wrong side of a regime change.