Pure equity strategies are not necessarily the best option for long-term investors, according to John Southall, head of solutions research at Legal & General.
Investors are told that they can make a higher return in equity markets over the long term, but Southall said they often underestimate the volatility involved.
Indeed, he said investors commit to highly volatile investments “without fully appreciating the gut-wrenching gyrations or potentially protracted periods of disappointment involved”.
Equities are at high risk of “sharp and brutal” downturns that can wipe out a significant portion of the total return investors have accumulated over time – something people can overlook when captured by the allure of higher returns.
Southall said: “There is a serious debate to be had about whether a pure equity strategy makes the most sense for long-term investors focused purely on ultimate outcomes.
“Over a multi-decade period there is a high chance of at least one huge drawdown. They should be confident this is something they can stick with, as this is much easier said than done.”
Pure equity portfolios might sound attractive on face-value, but investors might be able to avoid difficult drawdowns with diversified funds.
Southall predicted that more than half (52%) of pure equity portfolios will undergo a maximum drawdown of over 40% in a 40-year period, compared to just 5% of diversified funds.
Simulated returns on pure equity vs diversified strategies over a 40-year horizon
Source: Legal & General
These steep drawdowns can drag on long-term performance and be challenging to recover from, leaving even investors with the longest timeframes in a difficult position.
“Even younger investors, who cannot access their funds for decades, are vulnerable to its psychological impact,” Southall said. “They can’t disinvest but still have dangerous levers to pull if they lose faith.”
Young investors who become dissatisfied with seeing their investment fall could switch entirely to cash or, in a worst-case scenario, stop saving altogether.
It’s easy to see why investors are so willing to go all in on equities given the relatively low volatility of the past decade, according to Southall.
He said there hasn’t been a significant maximum drawdown in the US (other than the brief drop during the pandemic) for more than 15 years, so many investors have grown used to a low-volatile environment.
Drawdowns on US equities since 1926
Source: Legal & General
Investors have adjusted to these conditions and may be in for a shock if they haven’t diversified across different asset classes, according to Southall.
He said: “Are equity investors becoming complacent? We should remember that this is the history of US equity, which is a significant success story. Equity sceptics often cite selection bias of the US market in studies.”