The latest report from the Wells Fargo Investment Institute (WFII) is forecasting lower returns over most asset classes. Despite this, the report said, investors should fight the temptation to take on more risk to maintain returns.
In a report titled Balancing Risk and Reward, WFII predicted that returns for most investment assets over the next 10 to 15 years will underperform their historical averages. These include cash alternatives (hypothetical 10-15 year return of 2.5% vs. 2.6% historical average), US taxable investment-grade fixed income (3.1% vs. 5.9%), developed-market ex-US fixed income (2.8% vs. 5.4%), US large-cap equities (7.7% vs. 10.3%), emerging-market equities (9% vs. 9.7%), and public real estate (7.2% vs. 8.9%).
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The danger, according to WFII, is that the extended bull market and relative low volatility of recent years can lure investors into adopting greater levels of risk for potentially lower expected returns. “The recent resurgence in market volatility likely revealed that some investors had taken on more risk than they anticipated,” the firm said.
And while asset-price volatility is the most recognizable risk among investors, WFII noted that they should be wary of other risks. For instance, in light of the economy’s current latter-stage recovery and potential acceleration in inflation, there’s an expectation of tighter monetary policy from central banks that will likely hurt interest-rate-sensitive bonds.
Other market risks that investors tend to overlook are concentration risk, illiquidity risk, credit risk, currency risk, and geopolitical risk. The best way to protect against these is through diversification, which investors might be tempted to forgo as they concentrate on assets that are higher-risk — but not necessarily higher-reward.
“Taking on more risk does not necessarily result in greater returns over every time period and for every asset class,” WFII said. To illustrate, the firm looked at the 10-year period between January 1, 1998, and December 31, 2007, when US large-cap equity investors took on uncompensated risk. “During that period of time, US large-cap equities and bonds returned exactly the same amount: 6.0%. Yet, stocks remained more volatile than bonds.”
Based on an analysis of hypothetical returns and potential risks for each asset class, the firm estimated unfavourable risk-return trade-offs for high-yield taxable fixed income, developed-market ex-US fixed income, and commodities. It estimated favourable trade-offs for real estate investment trusts and hedge funds.
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