Long run returns on bonds and equities

Given the huge amount of uncertainty which is around, the FTSE index remains remarkably resilient. It currently sits almost bang in the middle of the 7000 – 7600 range where it has been since the beginning of January 2017.

Brexit does not seem to trouble share prices. Nor do the threats by John McDonnell, Labour’s shadow Chancellor, to carry out extensive raids on shares and put workers on the boards of companies.

As the saying goes, these risks and uncertainties are “priced in” by the market. The concept of market efficiency, revered by economists, means that all available information is taken into account in the process of setting share prices.

The implication is that pension funds and traders alike appear to attach only a small probability to a disruptive Brexit or to Labour forming a government.

Of course, it is precisely when an unexpected disruptive event takes place that the market ceases to be efficient.

Market participants need time to absorb and process the implications of the new environment, and do so at different speeds. There is widespread disagreement about what the “rational” price of an asset is, and as a result volatility abounds.

Despite the sanguine way in which the market is currently behaving, there must be many who are nevertheless casting anxious eyes back over their shoulders.

They can take comfort from an article published in the latest Quarterly Journal of Economics by Oscar Jorda, of the University of California, and colleagues. Its findings represent an important addition to scientific knowledge.

The authors publish estimates of the annual total returns on equities, housing, long term government bonds and short-term fixed interest government securities (3 month Treasury bills in the UK).

The impressive nature of the work is not simply that it covers 16 advanced economies. Data is provided for every year between 1870 and 2015

Government debt in countries such as the US and the UK is considered to a be a very “safe” asset. One of the most remarkable findings of the research is that the real return, , in other words gains after allowing for inflation, on such assets has been very volatile, often even more so than the supposedly “risky” assets such as equities.

This is quite contrary to the conventional view of how the world is supposed to work. If an asset gives a higher return than another, the expectation is that its price is more volatile. There is a trade off between risk and return. But this seems not to be true.

Intriguingly, both equities and residential real estate have yielded total real gains of no less than 7 per cent a year. Housing outperformed shares from 1870 until World War Two, and the position has been reversed since then.

Governments come and governments go, as indeed have two major world wars. But over the course of well over a century, holding equities and not worrying about short term fluctuations has yielded rich rewards. Obviously, the past is not necessarily a guide to the future. But the past here spans evidence from nearly 150 years.

Paul Ormerod