In the sector press
Ready for a Fall
Kate Rogers, Portfolio Director and Head of Policy at Cazenove Charities shares her thoughts on issues faced by the charity sector in Third Sector Magazine every other month.
What are the 'safe' investments? Perceived wisdom would rank possible investments in order of their volatility, the amount they oscillate in value, as a proxy for their safety. On this basis cash is safest, followed by bonds, property and then, at the riskier end, equities. It follows that you would expect to get a higher return for the most risky assets and the lowest return for the safest. This has been shown to be the case over very long periods (over 30 years), but over shorter time horizons often it is not.
Let us use a simple example to show why a share price might go up or down. Imagine that I run a company making sunglasses. I sell shares of my company to a number of investors. How do they decide what price to pay for that share? They would look at how many sunglasses I am selling and how many I am likely to sell in the future. They would work out a price based on my earnings. This is a 'valuation', or in this instance a price to earnings ratio. Let us then imagine that weather forecasters predict that it is going to be a really hot summer. My shareholders are excited and expect me to sell more sunglasses and other investors are likely to pay a higher price for each share. My company just got more expensive because of what is expected to happen.
There is plenty of evidence to support the claim that it isn't what you buy, but the price that you pay for it that is the key to future returns. The cheaper shares often offer the best future returns. Not rocket science, but often difficult to put into practice as cheap prices often reflect pessimistic expectations.
This can help to explain how asset returns do not always follow the pattern that the ‘lowest risk gives the most dependable return’. Let us look at government bonds. Currently you can lend your money to the UK government by investing in a UK government bond for 10 years and it will give you a return of less than 2% per year. That is lower than their own target rate of inflation, suggesting you will be able to buy less with the proceeds of your investment in 10 years than you can today. Government bonds seem expensive.
Charities often hold bonds in their investment portfolios as safe assets, which they combine with riskier assets such as equities. This worries me. An increase in interest rates to ‘normal’ levels – those typical at these levels of growth and inflation - would currently correspond to a 15% fall in the 10 year government bond price. On valuation grounds, you would only wish to hold bonds now if you believe that deflation is a threat and that interest rates will stay at these historic low levels.
Although theory tells us that the least volatile investments should provide the most dependable return, this is not always the case. Today charities should be wary of bond markets which may be ready for a fall.
A version of this article first appeared in Third Sector on 26 March 2015. For this and other articles by Kate Rogers, visit thirdsector.co.uk
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