Markets have dealt them a bad hand. They could be playing it better
Young investors, as well as everyone starting to save, have no shortage of lessons to learn. The main ones are classics. Begin early to give the magic of compounding time to work. Cut costs to stop that magic from being undone. Diversify. Do not try to time the market unless it is your job to do so. Stick to your strategy even when prices plummet and the sky seems to be falling in. Do not ruin it by chasing hot assets when the market is soaring, others are getting rich and you are getting jealous.
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. ■