Is it sensible to hold a portfolio that is entirely invested in equities?

Is it sensible to hold a portfolio that is entirely invested in equities?

Image by Pete Linforth from Pixabay

Given the battering which investors in some types of bonds have taken in the last few months, it’s understandable when the question arises as to whether they might be better to eschew such assets altogether and opt to invest solely in equities.

In the long term, the case for equities is compelling.  Over the period from 1956 to 2022, a diversified portfolio of listed UK equities would have delivered over 11% annually on average.  However, even in the relatively short term, its returns have been pretty reasonable, as the figures below show.

Data source: Dimensional UK market Index data, income reinvested net of tax via ReturnsWeb

Indeed, contrary to what you might expect, over this period an investor in such a portfolio would have been more likely to have earned a return of more than 20% in a calendar year (22 years) than to have experienced a loss (17 periods).

Combined with the fact that over the long term, investors in equities have seen higher returns than either cash or bonds, it is not unreasonable to question why anyone should even bother with other assets.

However, one of the key words here is ‘anyone’.  Not all investors are the same and neither are their willingness, need or capacity to withstand the variability of such returns.

If you are in your 20s or 30s and your investment goal is to accumulate funds for your financial independence from paid work when you are in your 50s, 60s and beyond, it definitely makes sense to invest those funds heavily or entirely in equities.  The greatest risk for an equity investor is a market crash in which share prices fall.  However, as long as you can afford to continue saving at the same rate as before, you now have the opportunity to hoover up assets at lower prices, which means that you buy more of them for the same money.  Your greatest asset at such times is your own earning power and hence your ability to continue saving excess income for your future needs.  Meanwhile you have a long time to ride out falls and to wait for prices to recover.

However, as the date when paid work becomes optional rather than necessary approaches, the value of our human capital reduces (we have fewer salary payments ahead of us).  Our financial assets then need to take over the burden of supporting our lifestyle costs.  In such circumstances, the amount of time available to wait for prices to recover is more limited, as is our ability to save more to compensate for those falls.

Consequently most investors opt to allocate a larger proportion of their portfolio to defensive assets (such as cash and bonds) which are less likely to fall as far as equities when market sentiment turns negative.

As research by AJ Bell[i] shows, the average UK bear market lasted just over a year and resulted in a 37% decline.  However it then averaged nearly two years to recover back to its previous level.  Like all averages, these figures mask a wide range, the worst in recent times being the 2007-09 Global Financial Crisis in which it fell 49% over 617 days but then took over four years to recover.  Since some of those falls included bear market rallies (the infamous ‘dead cat bounce’) in which recoveries were followed by greater declines, the 2007-09 period including no fewer than seven of them, anyone tempted to buy on falls needed a strong stomach to stay the course.  I remember us doing that at the time and it wasn’t easy although it did work out in the end.

While it’s one thing to buy into a market when prices are lower, it’s much less palatable to have to sell out of one at the same time because you need to pay the bills.  If your portfolio is entirely in equities, this can lead to experiencing a permanent loss because you are a forced seller.  Since the whole rationale behind moving from an accumulation to a distribution phase with a portfolio is to avoid this happening, this is the point of holding those defensive assets – to limit the extent of any overall fall or even to give an alternative source from which cash can be withdrawn.

Yet even when you aren’t still accumulating by adding capital to your portfolio, there is merit in continuing to compound your gains by holding assets whose returns are likely to be higher than the lower risk alternatives.  Consider the following example, in which savings are a constant £10,000 annually for 40 years and annual returns 5%.  Although after 20 years, the gains account for only 42% of the total, after another 20 this has increased to 68% due to compounding.

Data source: Bloomsbury Wealth

This goes to illustrate the importance of maintaining your savings rate while young but maintaining the investment in later years.

Still, there is (almost) never a free lunch and there are some other things to consider when contemplating what is right for you.  Despite its long-term benefits, investing can deliver nasty shocks with unpredictable timing.  Although in general, dividends from a diversified portfolio tend to rise over time, this is not inevitable and when companies are under pressure, they can still cut distributions to shareholders.  Most recently, we saw banks instructed to do so during the pandemic as governments demanded that they prioritise the interests of customers over those of shareholders.

Then again, from time to time we can face unplanned calls on our finances, whether to replace the car or the roof or to meet medical or care costs.  This is where an emergency fund of highly liquid assets such as cash comes in handy and this might increase after paid work stops so as to provide a larger buffer between expenditure and the portfolio.

There is also the simple psychological question of how well you can sleep at night.  Regardless of the rational argument for retaining a portfolio that is substantially invested in risky assets, if you can’t live with the prospect of wild fluctuations in its value from one day to the next, you probably won’t stay the course and instead exit – probably at a low point.  If the relationship between the value of your available resources and that of your expected outflows is such that you don’t need to accept that extra risk, why accept the extra stress?

The decision around what high-level allocation is appropriate for your portfolio depends on a number of factors and what is perfect for one person may be the opposite for another who has different circumstances and attitudes.  Your portfolio and your long-term plan have to be suited to you and basing it on what someone else does is unlikely to lead to your own financial security and happiness.

This article is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.