To this time-worn list, add an altogether more dispiriting lesson specific to today’s youngsters: you will not enjoy anything like the returns your parents made. Even accounting for the global financial crisis of 2007-09, the four decades to 2021 were a golden age for investors. A broad index of global shares posted an annualised real return of 7.4%. Not only was this well above the figure of 4.3% for the preceding eight decades, but it was accompanied by a blistering run in the bond market. Over the same period, global bonds posted annualised real returns of 6.3%—a vastly better result than the 0% of the preceding 80 years.

That golden age is now almost certainly over. It was brought about in the first place by globalisation, quiescent inflation and, most of all, a long decline in interest rates. Each of these trends has now kicked into reverse. As a consequence, youngsters must confront a more difficult set of investment choices—on how much to save, how to make the most out of markets that offer less and how to square their moral values with the search for returns. So far, many are choosing badly.

The constant refrain of the asset-management industry—that past performance is no guarantee of future returns—has rarely been more apt. Should market returns revert to longer-run averages, the difference for today’s young investors (defined as under-40s) would be huge. Including both the lacklustre years before the 1980s and the bumper ones thereafter, these long-run averages are 5% and 1.7% a year for stocks and bonds respectively. After 40 years of such returns, the real value of $1 invested in stocks would be $7.04, and in bonds $1.96. For those investing across the 40 years to 2021, the equivalent figures were $17.38 and $11.52.

This creates two sources of danger for investors now starting out. The first is that they look at recent history and conclude markets are likely to contribute far more to their wealth than a longer view would suggest. A corollary is that they end up saving too little for retirement, assuming that investment returns will make up the rest. The second is even more demoralising: that years of unusually juicy returns have not merely given investors unrealistically high hopes, but have made it more likely that low returns lie ahead.

Antti Ilmanen of aqr, a hedge fund, sets out this case in “Investing Amid Low Expected Returns”, a book published last year. It is most easily understood by considering the long decline in bond yields that began in the 1980s. Since prices move inversely to yields, this decline led to large capital gains for bondholders—the source of the high returns they enjoyed over this period. Yet the closer yields came to zero, the less scope there was for capital gains in the future. In recent years, and especially recent months, yields have climbed sharply, with the nominal ten-year American Treasury yield rising from 0.5% in 2020 to 4.5% today. This still leaves nowhere near as much room for future capital gains as the close-to-16% yield of the early 1980s.

The same logic applies to stocks, where dividend and earnings yields (the main sources of equity returns) fell alongside interest rates. Again, one result was the windfall valuation gains enjoyed by shareholders. Also again, these gains came, in essence, from bringing forward future returns—raising prices and thereby lowering the yields later investors could expect from dividend payouts and corporate profits. The cost was therefore more modest prospects for the next generation.

As the prices of virtually every asset class fell last year, one silver lining appeared to be that the resulting rise in yields would improve these prospects. This is true for the swathe of government bonds where real yields moved from negative to positive. It is also true for investors in corporate bonds and other forms of debt, subject to the caveat that rising borrowing costs raise the risk of companies defaulting. “If you can earn 12%, maybe 13%, on a really good day in senior secured bank debt, what else do you want to do in life?” Steve Schwarzman, boss of Blackstone, a private-investment firm, recently asked.

Even so, the long-term outlook for stocks, which have historically been the main source of investors’ returns, remains dim. Although prices dropped last year, they have spent most of this one staging a strong recovery. The result is a renewed squeeze on earnings yields, and hence on expected returns. For America’s s&p 500 index of large stocks, this squeeze is painfully tight. The equity risk premium, or the expected reward for investing in risky stocks over “safe” government bonds, has fallen to its lowest level in decades (see chart 1). Without improbably high and sustained earnings growth, the only possible outcomes are a significant crash in prices or years of disappointing returns.

All this makes it unusually important for young savers to make sensible investment decisions. Faced with an unenviable set of market conditions, they have a stronger imperative than ever to make the most of what little is on offer. The good news is that today’s youngsters have better access to financial information, easy-to-use investment platforms and low-cost index funds than any generation before them. The bad news is that too many are falling victim to traps that will crimp their already meagre expected returns.

A little flush

The first trap—holding too much cash—is an old one. Yet youngsters are particularly vulnerable. Analysis of 7m retail accounts by Vanguard, an asset-management giant, at the end of 2022 found that younger generations allocate more to cash than older ones (see chart 2). The average portfolio for Generation Z (born after 1996) was 29% cash, compared with baby-boomers’ 19%.

It could be that, at the end of a year during which asset prices dropped across the board, young investors were more likely to have taken shelter in cash. They may also have been tempted by months of headlines about central bankers raising interest rates—which, for those with longer memories, were less of a novelty. Andy Reed of Vanguard offers another possibility: that youngsters changing jobs and rolling their pension savings into a new account tend to have their portfolios switched into cash as a default option. Then, through inertia or forgetfulness, the vast majority never end up switching back to investments likely to earn them more in the long run.

Whatever its motivation, young investors’ preference for cash leaves them exposed to inflation and the opportunity cost of missing out on returns elsewhere. The months following Vanguard’s survey at the end of 2022 provide a case in point. Share prices surged, making gains that those who had sold up would have missed. More broadly, the long-run real return on Treasury bills (short-term government debt yielding similar rates to cash) since 1900 has been only 0.4% per year. In spite of central banks’ rate rises, for cash held on modern investment platforms the typical return is even lower than that on bills. Cash will struggle to maintain investors’ purchasing power, let alone increase it.

The second trap is the mirror image of the first: a reluctance to own bonds, the other “safe” asset class after cash. They make up just 5% of the typical Gen Z portfolio, compared with 20% for baby-boomers, and each generation is less likely to invest in them than the previous one. Combined with young investors’ cash holdings, this gives rise to a striking difference in the ratio between the two asset classes in generations’ portfolios. Whereas baby-boomers hold more bonds than cash, the ratio between the two in the typical millennial’s portfolio is 1:4. For Gen Z it is 1:6.

Given the markets with which younger investors grew up, this may not be surprising. For years after the global financial crisis, government bonds across much of the rich world yielded little or even less than nothing. Then, as interest rates shot up last year, they took losses far too great to be considered properly “safe” assets.

But even if disdain for bonds is understandable, it is not wise. They now offer higher yields than in the 2010s. More important, they have a tendency to outpace inflation that cash does not. The long-run real return on American bonds since 1900 has been 1.7% a year—not much compared with equities, but a lot more than cash.

The name of the third trap depends on who is describing it. To the asset-management industry, it is “thematic investing”. Less politely, it is the practice of drumming up business by selling customised products in order to capture the latest market fad and flatter investors that they are canny enough to beat the market.

Today’s specialised bets are largely placed via exchange-traded funds (etfs), which have seen their assets under management soar to more than $10trn globally. There are etfs betting on volatility, cannabis stocks and against the positions taken by Jim Cramer, an American television personality. More respectably, there are those seeking to profit from mega-themes that might actually drive returns, such as ageing populations and artificial intelligence. An enormous subcategory comprises strategies investing according to environmental, social and governance (esg) factors.

Niche strategies are nothing new, and nor are their deficiencies. Investors who use them face more volatility, less liquidity and chunky fees. Compared with those focused on the overall market, they take a greater risk that fashions will change. Even those who pick sensible themes are competing with professional money managers.

However the ease with which etfs can be customised, advertised and sold with a few taps on a phone screen is something that previous generations of investors did not have to reckon with. So is the appeal to morality accompanying their marketing. esg vehicles are presented to youngsters as the ethically neutral option. If there are investments that will save society and the planet while growing your savings at the same time, what kind of monster would buy the ordinary, dirty kind?

This both overstates the difference between esg and “normal” funds, and papers over their impact on costs and returns. According to a recent study by the Harvard Business School, funds investing along esg criteria charged substantially higher fees than the non-esg kind. Moreover, the esg funds had 68% of their assets invested in exactly the same holdings as the non-esg ones, despite charging higher fees across their portfolios. Such funds also shun “dirty” assets, including fossil-fuel miners, whose profits are likely to generate higher investment yields if this shunning forces down their prices.

Next to the vast difference between the investment prospects of today’s youngsters and those of their parents, the benefits to be gained by avoiding these traps may seem small. In fact, it is precisely because markets look so unappealing that young investors must harvest returns. Meanwhile, the investment habits they are forming may well last for some time. Vanguard’s Mr Reed points to evidence that investors’ early experiences of markets shape their allocations over many years.

Ordering the portfolios of Vanguard’s retail investors by the year their accounts were opened, his team has calculated the median equity allocation for each vintage (see chart 3). The results show that investors who opened accounts during a boom retain significantly higher equity allocations even decades later. The median investor who started out in 1999, as the dotcom bubble swelled, still held 86% of their portfolio in stocks in 2022. For those who began in 2004, when memories of the bubble bursting were still fresh, the equivalent figure was just 72%.

Therefore it is very possible today’s young investors are choosing strategies they will follow for decades to come. Mr Ilmanen’s treatise on low expected returns opens with the “serenity prayer”, which asks for “the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference”. It might be the best investment advice out there.
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Investing

Five books on the best approaches to being an investor

 

Most people would like to find an easy way to get rich, just as they might want a quick way to get thin, or play a musical instrument. But it is a mistake for novice investors to assume that they can find instant success in achieving high returns when professionals, armed with extensive research and sophisticated technology, struggle to do so. Of course, just as people might get lucky at roulette, they might pick a wonder stock, but the odds are against them. Long-term prosperity can best be achieved by investors who save as much as they can afford in a low-cost fashion and in an asset class that reflects the long-term growth of the economy and the corporate sector. Even then, investors can be unlucky if they start saving in the wrong era (1920s America or 1980s Japan) or if governments seize their assets. These five books provide useful lessons on what approaches to take and, just as importantly, what steps to avoid.

The Intelligent Investor. By Benjamin Graham. (Revised edition, updated with new commentary by Jason Zweig.) HarperCollins; 640 pages; $20.99 and £18.99

This is the foundational text for serious investors, written by the mentor of Warren Buffett, arguably the most successful investor of the modern era. Ben Graham was the archetypal “value investor”, looking for bargains in the market. He honed his skills after the Wall Street crash of 1929 when equity valuations had plunged. Accordingly, some of his methods for finding bargains are difficult to apply today when stocks are more expensively valued. But his principles remain sound. Much depends on the price paid for stocks, so beware of fashionable industries. As he notes “obvious prospects for physical growth in a business do not translate into obvious prospects for investors”  whereas “a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity”.

The Clash of the Cultures. By John Bogle. Wiley; 385 pages; $29.95 and £22.99

Like Ben Graham, Jack (as he was usually known) Bogle focused on the difference between investment and speculation. But rather than buy individual stocks, Mr Bogle believed that investors should have exposure to the broad stock market. He was thus the father of the tracking fund which mimics the behaviour of benchmarks like the S&P 500 index. He also set up the Vanguard group, a mutually-owned company which offers low-cost trackers and is one of the world’s largest institutional investors. Mr Bogle was the author of many books but this one, published in 2012 towards the end of his life, sums up his message. Too many investors pursue hot stocks and hot funds; they buy high and sell low, and pay high fees to the financial sector in the process. As he writes: “investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs.” Read our full review of the book.

Lying for Money. By Dan Davies. Scribner; 304 pages; $28. Profile Books; £10.99

Trading too often, and paying high fees, are two pitfalls faced by the average investor. The third is succumbing to financial fraud. This entertaining book, published in 2018, describes some of the most common scams. If there is a shared theme, it is that investors simply can’t be bothered to check the details when the rewards look great. Although regulators can fall asleep at the wheel, fraud is more common in unregulated areas, as the history of cryptocurrencies has shown. The golden rule is to watch out for extremely rapid growth; such examples need to be checked thoroughly. As the saying goes “If it seems too good to be true, it probably is.”

Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh and Mike Staunton. Princeton University Press, 352 pages; $180 and £150

One of the highlights of the investment year is the annual review of financial markets produced by three academics from London Business School, most recently in association with Credit Suisse (a bank that perhaps could have paid better heed to the advice therein). The trio has assembled a trove of data from around the globe, focusing on the returns from shares, bonds and Treasury bills. They summed up the 20th century in a book, published in 2002, which helped to explain why “the cult of the equity” had developed—namely that shares had consistently outperformed other asset classes. But the book also provides a useful corrective. America’s great success tends to skew investor impressions. Elsewhere, investors have seen their savings wiped out by hyperinflation or revolutionary governments. Just because the optimists were right in the 20th century doesn’t mean they will always be proved right in the 21st. Read our full review of the book.

Investing Amid Low Expected Returns. By Antti Ilmanen, Wiley; 304 pages; $21.99 and £21.99

The last book in the list was written by an academic-turned-investor, and thus has more of a bent towards investment professionals. Nevertheless, small investors will gain a lot from reading this tome, an update on the author’s excellent earlier work “Expected Returns”. The main thesis is that the low yields on bonds and equities that prevailed at the time of publication will reduce the likely returns on investment (making them lower than those described in “Triumph of the Optimists”). The thesis appeared to be borne out by a horrible year for both bonds and equities in 2022, the year it was published. But the book also provides an excellent explanation of many different strategies from momentum investing (buying assets that have risen in price) to private equity. The book was reviewed here by our Buttonwood columnist.
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How to avoid a common investment mistake

Think less about what to buy, and more about how much

If you ever hear a professional investor talk about a trade that taught them a lot, prick up your ears. Usually, this is code for “a time I lost an absolutely colossal amount of money”, and you are in for one of the better stories about how finance works at the coalface.

On this front, Victor Haghani is a man to whom it is worth listening. He spent the mid-1990s as a partner and superstar bond trader at the hottest hedge fund on Wall Street. In its first four years, Long-Term Capital Management (ltcm) made its initial backers average returns of more than 30% a year and never lost money two months in a row. Moreover, its partners had been trading the capital of Salomon Brothers, an investment bank, for the preceding 20 years, with similar results. But in 1998 the wheels came off in spectacular fashion. ltcm lost 90% of its capital at a stroke. Despite a $3.6bn bail-out from a group of its trading counterparties, the fund was liquidated and its partners’ personal investments wiped out. Mr Haghani writes that he took “a nine-figure hit”.

Now, along with his present-day colleague James White, he has written a book that aims to spare other investors his mistakes. Fortunately, “The Missing Billionaires” is not a discussion of the minutiae of ltcm’s bond-arbitrage trades. Instead, it examines what its authors argue is a much more important—and neglected—question than picking the right investments to buy or sell: not “what” but “how much”.

People tend to answer this question badly. To show this, the book describes an experiment in which 61 youngsters (college students of finance and economics, plus some young professional financiers) were given $25 and asked to bet on a rigged coin at even odds. Each flip, they were told, had a 60% chance of coming up heads. They had time for about 300 tosses, could choose each bet’s size and would keep their winnings up to a cap of $250. This was an exceptionally good deal: simply betting 10% of the remaining pot on each toss had a 94% chance of yielding the maximum payout and none of going bust. Yet the players’ average payout was just $91, only a fifth of them hit the cap and 28% managed to lose everything.

A list of the coin-flippers’ mistakes reads like a parable of how not to invest in the stockmarket. Rather than picking a strategy and sticking to it, subjects bet erratically. Nearly a third wagered their entire pot on a single flip and, amazingly, some did so on the 40% chance of getting tails. Many doubled down on losses, even though doing so is a reliable way of making mild ones catastrophic. Others made small bets fixed in dollar amounts, avoiding ruin but also giving up the lion’s share of their potential returns. Few considered the optimal, lucrative strategy of betting a constant fraction of their wealth on an attractive opportunity.

The rest of the book offers a corrective to these wealth-sapping instincts. Most important is to devise rules for spending, saving and allocating investments, expressed as fractions of your total wealth. Then you must stick to them, avoiding the temptation to chase hot assets or spend too much in the face of losses.

The authors’ great success is in offering a consistent and explicit framework within which to do all this. At its core is the concept of “expected utility”, or the pleasure derived from a given level of wealth. This accounts for the fact that most people are averse to risking large chunks of their capital. A happy consequence is that sizing investments to maximise expected utility, rather than wealth, can sharply reduce your chances of intolerable losses while keeping enough risk for a shot at decent returns.

In practical terms, the book’s crowning achievement is its explanation of the “Merton share”. This is a simple rule of thumb for determining asset allocation, which says that allocations should rise in proportion to expected returns, fall in proportion to the investor’s risk aversion and fall a lot in proportion to volatility (specifically, to its square).

This is not to suggest the book makes for light reading. The authors prescribe calculations that will appeal to only the most dogged investors, ideally with access to a Bloomberg terminal. Most will conclude that they need a wealth-management firm to help them; conveniently enough, Messrs Haghani and White run one. Yet for those investing in their own business—or, indeed, a hotshot hedge fund—it is worth reading simply for Mr Haghani’s reflection on how much he ought to have ploughed into ltcm all those years ago. Spoiler alert: it was rather less than he did.
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Investors are returning to hedge funds. That may be unwise

Look beyond the current turbulence

Superheroes are useless when times are good. If Gotham was a safe and pleasant place, Batman would probably just spend his days relaxing in a mansion upstate. Superman only ducks into a phone booth to reveal his blue-and-red lycra when the bad guys are holding someone up at gunpoint.

For the best part of a decade, financial markets were mostly serene. The s&p 500 index, the leading measure of American stocks, climbed steadily higher from 2010 to 2020. With expected interest rates edging lower and lower, bond prices also floated mostly up. Investors worried about missing out on the bull market of a lifetime, not about whatever risks lay around the corner. The circumstances were thus abysmal for institutions that aim to be useful in turbulent times, such as hedge funds. They often seek returns that are uncorrelated with the broader stockmarket, in order to ease the blow an investor’s portfolio might take when markets fall. In volatile markets, a superhero manager—call him hedge-man—is supposed to swoop in and protect investors from losses.

Hedge funds were a difficult sell for much of the 2010s. Investors stuck with them for the first half of the decade. But as returns continued to lag those of the stockmarket, net asset growth (a measure of whether investors are pulling money from or putting money into funds, stripping out the impact of investment returns) turned negative. In the second half of the decade, hedge funds bled money and hedge-man hung up his cape. In almost every year since 2015 more funds closed than opened.

After a torrid decade, things are now looking better for hedge-man. Money has, on net, flowed into funds in every quarter this year. If business continues at the same pace, 2023 will be the best year for hedge funds since 2015. The total sum invested in funds is now more than $4trn, up from $3.3trn at the end of 2019. And this year more funds have opened than closed.

What to make of hedge-man’s return? Maybe investors are heavily influenced by recent events. Last year hedge funds beat the market. The Barclays Hedge Fund Index, which measures returns across the industry, net of fees, lost a mere 8%, while the s&p 500 lost a more uncomfortable 18%. Yet hedge funds have in aggregate heavily underperformed American equity indices in all other years since 2009, returning an average of just 5% a year across the period, against a 13% gain for the broader market. In 2008 Warren Buffett, a famous investor, bet a hedge-fund manager $1m that money invested in an index fund would outperform that in a hedge fund of his choosing over the next decade. Mr Buffett won comfortably.

The renewed enthusiasm for hedge funds might also suggest a deeper disquiet: perhaps people have become convinced the easy returns of the 2010s are now well and truly a thing of the past. Most investment portfolios have been buffeted by the end of easy monetary policy. As Freddie Parker, who allocates money to hedge funds for clients of Goldman Sachs, a bank, has noted, the performance of hedge funds tends to look healthier during periods of rising rates, as these are generally accompanied by a “more challenging environment” for asset returns. Hedge-fund performance has also been stronger during periods in which interest rates were high or volatile, such as the 1980s and mid-2000s.

Of course, high interest rates do not necessarily mean the good old days are back for hedge-man. Today’s markets are higher-tech and lightning quick. Information spreads across the world just about instantaneously and is immediately incorporated into prices by high-frequency trading algorithms. By contrast, in the 1980s it was still possible to gain an edge on your rivals by reading the newspaper on the way into the office. Even though many hedge funds shut their doors in the 2010s, there are still far more around than there were in the 1980s or 1990s. Competition—for traders and for trades—is much stiffer than it was.

It is understandable that, when faced with a world in which interest rates are high and volatile, investors seek the return of those who might spare them from peril. But consider how Mr Buffett’s bet played out. In 2008, a woeful year for stocks, his index was handily beaten by hedge funds. It was the outperformance over the following nine years that won him the wager. “It is always darkest before the dawn,” says Harvey Dent, a rival to Batman, in one of the films, “and, I promise you, the dawn is coming.” When it arrives, investors may wish they had stuck with their index funds.