Investing in the '70s: were there any winners?

n's"

is a function of the perceived riskundertaken. The results of takingthe risk may be radically differentfrom what the investor expected.

The assets shown in Table I arein ascending order of perceivedrisk. The expected return includesboth interest or dividend yields plusthe capital appreciation of the se-curity. It is assumed that risk ismeasured by the difference betweenreturns and their expected value.However, as we mentioned earlier,investors don't always realize theirexpectations.

In a study of investment returnsover the past 10 years, we madesome surprising discoveries. On abefore-tax basis, savings accountsand Government of Canada 3-yearbonds yielded negative real (price-adjusted) returns. Industrial bondsand soybeans yielded only slightlypositive before-tax real returns.Conventional mortgages yielded thehighest annual increase in purchas-ing power among the fixed-incomesecurities. Purchasing silver bullion,as it turned out, was the best pro-tection against inflation.

Low returns on common stocks

A representative portfolio ofcommon shares, based on the Dow-Jones industrial index, yielded noincrease in purchasing power overthe period. Even though companyprofits increased nominally, the ra-tios of share prices to earnings fellsufficiently to eliminate any realgains. Canadian common shares,represented by those shares tradedon the Toronto Stock Exchange(Toronto Stock Exchange com-posite 300 industrial index) showedstronger returns due to the highconcentration of energy and miningshares and possibly to the increasednumber of acquisitions that tookplace in the latter part of the de-cade.

In general, the structure of real-ized returns reflected the perceivedrisk although, as shown in Table II,the US shares were an exception.The most striking finding, however,was the very low (in some casesnegative) real returns realized formost of the investments.

nadian common shares and silvershowed positive returns at moder-ate-to-high marginal personal taxrates. The investment performanceof gold and platinum was similar,although not quite as dramatic, assilver.

Investors with low marginal taxrates of 30% or less may, in fact,have realized positive real returns.Other compounding factors such aslow interest, grossed up dividends,and capital gain exemptions makeit difficult to make an after-taxstatement.

Negative after-tax real returns

Let us examine the negativeafter-tax real returns with referenceto the experience of an investorwho is holding Government of Can-ada bonds. As Table I shows, thecompounded annual returns were7.53% and the investor has suf-fered a purchasing power loss of0.7% per year. Why were investorswilling to risk making this invest-ment? There are various plausible

explanations. First, it is possiblethat bond investors, in the aggre-gate, consistently underestimatedthe inflation level in the 1 970s;therefore, the required premium forinflation was set consistently toolow. A second possibility is that in-vestors, in the aggregate, failed topredict the sharp increase in inter-est rates in the 1 970s. The resultwas that realized returns were lessthan expected because the risktaken was too low to accommodatefluctuating interest rates. It is like-ly, in fact, that the low realized re-turns reflect the fact that rising in-flation and interest rates were bothunderestimated, since the interestrate phenomenon was closely tiedto inflation rates. A third explana-tion would lead us from theorizingabout and analysing expectations towhat is called segmentation theory.Segmentation theory would implyan inability (legal or otherwise) orreluctance on the part of investorsto alter the risk and maturity char-acteristics of their portfolio.

Real returns are expressed beforetax. On an after-tax basis only Ca-

472 CMA JOURNAL/FEBRUARY 15, 1981/VOL. 124

It is plausible that the capitalmarket is dominated at various riskand maturity levels by borrowerswho are powerful enough to dictateterms to the lenders. Lenders thenbecome simply price takers who, ifthey wish to invest in a particularrisk class or maturity range mustaccept the current yield or invest inassets that will have lower yields.Hence, in the situation we werediscussing, it is conceivable that in-vestors faced with such a dilemmacould, in fact, select investmentswith negative expected real returnsafter tax, since alternatives mayyield even lower real returns or beinherently more risky.

Two possible explanations

There are, therefore, two pos-sible explanations. First, investorsanticipated the rising interest andinflation rates and hence failed toinclude suitable risk premiums (theexpectations theory).- Or, second,interest rates and inflation were to-tally, or at least partially, anticip-ated but investors were powerlessto change the yield of securitieswithout accepting additional, unde-sired risk (the segmentation theory).What lessons can we derive from

investors' unhappy experiences in

the 1 970s? Clearly investment port-folios should be diversified for pro-tection against all forms of risk,particularly interest-rate and pur-chasing power risks.

People who avoid rational risk,recognizing that they do not pos-sess superior forecasting techniques,will realize that they cannot predictfuture interest rates, inflation andexchange-rate levels; therefore, theyhedge against future fluctuations inthese factors and thereby protectthemselves against adverse move-ments, while recognizing at the timethat they are giving up the oppor-tunity to earn windfall profits.

Interest-rate risk can be hedgedthrough the acquisition of securitiestied to a central interest-rate factorsuch as the prime rate or the 91-day treasury bill rate. If there is anincrease in interest rates, the cou-pon on the bond will rise sufficient-ly to maintain current market valuewhile the opposite will be true ifthere is a decline. Inflation risk isbest protected by holding basiccommodities such as grains, metalsand foods. A proxy for such cum-bersome holdings would be gold orsilver because their prices have beenshown in the past to be highly cor-related with inflation.E

CMAJ retrospect

"Over the March 1St weekend, following the British lead, theBank of Canada raised the discount rate from 6½ to 7%. Itlooks as though we are in for still another round of bank primerate increases. In the U.S. the prime rate at 7% has beenraised three times since December. It is now at the highestlevel in history." - CMAJ, March 1969.