If you think equities are riskier than bonds, think again

Andrew Dittberner and Rynel Moodley of Cannon Asset Managers debunk the myth that equities represent the riskiest asset class

Conventional wisdom tells us that bonds are safer than equities, and this argument is generally presented by showing equity to be more volatile than bonds. However, at Cannon Asset Managers, we have always seen this differently. We believe that true risk in investments is the permanent loss of capital.

Permanent loss of capital can occur as a result of the following three situations:

1. Overpaying for an asset
2. An issuer going bankrupt
3. Not being compensated for inflation

Given the events that have taken place in the European Union over recent years, it is evident that despite what we are taught about government bonds being the “risk-free” asset class, at times they can be anything but. Not only is there the very real risk of default, but there is an even better chance that an investor could lose money in real terms if invested in bonds. In other words, bonds do not adequately compensate investors for inflation.

In conducting our research, we analysed data on the South African market over the past 50 years, and compared the real and nominal returns over 5 and 10 year rolling periods.

Table 1 shows the 5-year rolling period results. This reveals that over the past 50 years bonds have produced a negative real return 43% of the time, whereas equities have only done so 11% of the time. However, comparing the volatility over the same period shows that equities are not significantly more volatile than bonds (7.9% versus 5.3%). Over the same period bonds have returned an annual average real return of 1.5%, while equities have returned a real 9.2% per annum. So for taking on a small amount of additional volatility in the form of equities, investors reduce their chances of negative real returns by about 75%.

Table 1: Bonds vs Equities (50 years of data, 5-year holding period)

And if we turn our attention to 10-year period, then equities are actually less volatile than bonds (4.6% versus 4.3%) yet they still manage to outperform bonds over this holding period (Table 2).

Table 2: Bonds vs Equities (50 years of data, 10-year holding period)

Chart 1 shows the frequency of returns over the past 50 years. It demonstrates that, in real terms, bond performance is poorer than that of equities. The vast majority of returns from bonds fall into the 5% or lower categories (including negative real returns) while only a third of equity returns are found in that region. The bulk of real returns from equities lie above 5%.

Chart 1: Frequency of 5-year real returns
 (Click on image to enlarge)

For long-term investors (as opposed to traders), it is important to understand that if we take a long-term view, risk is actually measured as the permanent impairment of capital rather than the conventional measure of risk: standard deviation of returns. It is evident from the analysis that the probability of losing money (in real terms) is significantly reduced over time for equities whilst the probability of losing money (in real terms) for bonds remains significantly higher throughout the periods under consideration. In fact, the probability of a real loss of capital has been approximately 4 times higher in the bond market when measured over a 5-year period and about 9 times higher when measured over a 10-year period.

There is a general acceptance regarding the riskiness of equities which has led to investors believing that the less risky asset class is bonds. Given this misconception, we believe that it is important for investors to define what really constitutes risk to them over longer time frames, ideally five years or longer.