Cash should not be crowned king by investors with long time horizons as historically equities outperform it in the long-term.

It is now widely accepted that while the typical balanced-investment portfolio has an allocation to equities of between 50 per cent and 65 per cent, the actual allocation of risk – as measured by volatility of annual returns – is much greater. The proportion of risk to equities in such portfolios is more likely to be between 90 per cent and 95 per cent.

This is because returns on equities are more volatile than for most other investments when volatility is measured over one-year time frames. Equity returns are about twice as volatile as investments in property and infrastructure, four times more volatile than bonds and around seven times more volatile than cash.

On the face of it, a weighting of more than 90 per cent of a portfolio to a single risk seems excessive. However, these headline numbers don’t tell the full story.

Turning it round to time

In the first place risk, as measured by annual volatility, is not the right measure for long-term investors. As the holding period extends, the actual level of volatility declines. For example, over 20-year periods, the actual annual volatility of returns reduces by around three quarters.

Secondly, equities have proven over time to be a reliable source of income and capital growth, notwithstanding some lengthy periods of disappointment. Over the past 100 years, there have been only three decades when equity investors have not been rewarded relative to investing in bonds. The average extra return over the past 110 years from equities has been in the order of 3.5 per cent per annum globally and 6 per cent per annum for Australia. Negative returns for periods over a decade are extremely rare, occurring through the depression of the 1930s, following the boom of the 1990s and more recently through the GFC.

Therefore, the key question is whether the world has changed. It is difficult to conclude anything other than a negative response.

The third important consideration is the adaptability of entrepreneurs and managers. Shares represent the ownership of living businesses and such businesses are constantly adapting to the nature of their economic environment.

Even today, corporate profitability around the world is at very high levels, despite weak developed-world economic growth and extremely tight financial conditions.

Considering the aforementioned points, we get a very different picture of risk. In fact, the risk of not investing in equities for a long-term investor may be very great indeed.

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