This article is an update to previous articles of the same theme – an historical comparison of equity returns versus cash returns in the context of “risk”.
In the world of investment, risk is most often defined as some statistical measure of variability in returns, for example the standard deviation of annual returns. On that basis, investment in equities would be consider riskier than cash, and that is what we are constantly told. However, the key lesson from this article is based on the fundamental principle that risk is defined by your personal circumstances, goals and response to uncertainty – rather than some universal statistical measure.
For example, if your goal was to maximise the value of your investment portfolio (eg your super) in 20 years time and you are a person who does not panic and sell equities following a market downturn, then in fact cash is riskier than equities. That is, at almost any confidence level, you would be worse off in 20 years time if you invested in cash rather than equities, despite the wild ups and downs of equities on the way.
Don’t believe me? Check out the following charts based on publicly available historical return data. They show the total return, gross of tax (and excluding franking credits) for Australian Equities (as measured by ASX 200 total return index) and Australian Cash (as measured by 3 monthly Term Deposit rates as published by the RBA).
Data is up to the end of September 2020.
The returns are rolling compound average annual returns over 12 months, 5 years, 10 years and 20 years. Also shown (in the last chart) is the differential between the equities average return and cash average return over rolling 20 year periods – the retail “equity premium” if you like. It shows a long-term differential of around 5% p.a. with a gentle downward trend following the trend in the absolute returns.
Finally, note that the vertical axis (annual average return) uses the same scale for each chart (other than final chart) so that when you scroll down you can actually see the reducing variability as the averaging period gets longer.
Rolling 12 month returns
Rolling 5 year returns
Rolling 10 year returns
Rolling 20 year returns
Equity Risk Premium (differential between Equity and Cash returns) over 20 years
Note that the recent COVID-19 induced market correction is significant in the historical context, but at this stage does not appear to be any worse than some previous market downturns such as the Global Financial Crisis (which you can see clearly in all of the charts). Of course, the impact of COVID-19 is yet to play out fully and we might see a protracted market decline or stagnation that would lower the average returns from equities, even over long periods such as 20 years. Or, we might not see that. Who knows?
What the last chart does seem to show is that over the long-run (20 years +) markets are fairly efficient – they produce equity returns that maintain a relatively constant differential over cash returns, a differential of around 5% p.a. And just to be clear, a 5% p.a. additional return over 20 years results in an increase in wealth of around 150%.