No, not the W. Somerset Maugham classic but investing.  With the worst economic crisis for nearly 100 years, how do you plan a portfolio which will generate enough income when you want to retire? Continuing last week’s theme, markets tend to revert towards the average over time,  http://www.georgeemsden.co.uk/2009/07/how-long-is-a-piece-of-string/ but no one knows how long this may take and different markets behave…differently. Some markets like Japan, have not reached their long term average 13 years after the last bubble there.

All this from a fascinating talk by Stuart Fowler of www.nomonkeybusiness.co.uk speaking at a www.financialplanning.org.uk meeting. People who swim against the flow tend to be more interesting than the others and heart-warming to hear about the dangers of equities and the relative security of bonds.

His graph showing the relative uncertainty of various investment types, when measured in real terms, whatever the uncertain future inflation, says it all. Most certain or really “least uncertain” is Cash and similarly Index-Linked Gilts (ILG) – not ordinary government securities. Most uncertain is equities – but right up there next to them is the classic idiot’s refuge – Bonds. There may be a place for them in a portfolio, but in terms of certainty of wealth outcomes in real terms, hardly less certain than equities. We all now about the volatility of shares caused by professionals, punters, bored housewives, redundant bankers, lottery winners, other amateurs, Brits and foreigners all trying to be smarter than everyone else.

But with Bonds which include Government Securities (Gilts) too, the uncertainty arises from the inaccuracy of the market’s guess of future inflation, which is what makes up most of the nominal bond yield. Past experience shows markets to be hopeless at guessing long-run inflation. With shares, you also have the high uncertainty of real outcomes but at least you are likely to get paid a risk premium for bearing that risk.

In more detail, the equity risk premium is often described as being relative to cash. It is the expected return on equities (or the past achieved return, depending whether you are observing or projecting)  less the return on cash. If you are interested in real outcomes, such as what your retirement income will actually buy 30 years in the future, it is not logical to compare expected probable equity returns with cash, as the two assets have uncertain in outcomes for different reasons. Hence the relevant risk premium is relative to index-linked gilts.

For a planner, the argument is practical rather than academic. You can get a price for a risk-free approach anytime, by looking at the cost of  an appropriate index-linked gilt (matched to the time horizon you are planning for) or the real income paid by a fully-indexed annuity.

As Stuart put it, this is “taking bets off the table” or “leaving the casino” by replacing equities with ILG’s. Doing this lays off the inflation risk (the value of your income will be reduced by inflation) capital market risk (the value of your portfolio may fall) and longevity risk (you may live longer than your money) but at a known price.  If you prefer a foodie analogy,  think of equities as a curry that is just that bit too hot and ILGs as a yogurt mixed in to reduce the temperature, to make it edible.

In a sample portfolio for a 60 year old taking an agreed amount of income till age 90, the early years are fully matched by cash and index linked gilts, the later years by equities as there is enough time for mean reversion to work, and the middle years a mix of equities and index-linked gilts. Over the course of the plan as horizons shorten, the equity proportion falls but as a function of market conditions and not just the ticking of the clock.

Contrast this with some pension policies for example, where you may choose to invest in a Lifestyle fund. These will gradually switch the fund into deposits as the Retirement Date approaches, but take no account of changing market conditions or individual risk appetite. Both are defensive strategies where you are looking at protecting what you have, rather than waiting for or expecting something better.

Has to be said that the typical portfolio they have is about £2 million, but an interesting approach which ought to be applicable to any portfolio size.

Finally, to add to your knowledge of trivia, Gilts (gilt-edged securities) are so-called as the certificates you received when you bought them really did have gold leaf/paint around the edge, but this was before WW2.