According to a Google search, the earliest known usage of ‘a bird in hand is worth two in the bush’ dates back to the 15th century and relates to falconry.
I have no idea how difficult it is to catch a falcon, but clearly there is an element of uncertainty. If the success rate of capturing a bird is 50 per cent and you are risk averse, then indeed, a bird in hand is worth more than two in the bush.
Now before I go further down that rabbit hole, you might ask: ‘Why is a CIO talking about falcons and rabbit holes?” Well, there is a reverse parallel to the saying in the investment world, which leads investors to unnecessarily reduce their long-term returns.
In simplistic terms, there are two main objectives of investing: income generation (a bird in hand) and capital growth (the birds in the bush). As you might expect, the two objectives lead to very different portfolios.
A risk of under-performing
For instance, our income-focused asset allocation model has a 65 per cent allocation to bonds (or bond-like investments) and only 35 per cent into equities. However, our ‘moderately aggressive’ capital growth allocation has 54 per cent in global equities and only 27 per cent going into bonds. The rest is allocated to cash, gold and alternative strategies.
As most investors may know, asset allocation is the main driver of investment returns. Different asset classes produce different returns. And while it is incredibly difficult to forecast short-term returns, it gets easier over longer time horizons.
In our latest CIO Office annual refresh of long-term (7-year) annual expected returns, there is good news for investors. Expected returns went up across the board. Bonds are expected to generate 4 per cent returns per year, up from a mere 1 per cent at the beginning of 2022. For global equities, expected returns rose to over 7 per cent, from 5.4 per cent 12 months earlier.
One can immediately see that equities are expected to outperform bonds over the long run. This is hardly surprising. However, it has interesting implications for investors.
It means that it is highly likely that an income-focused investment strategy – given the high allocation to bonds – will significantly underperform a growth-oriented strategy with its greater exposure to equities. Naturally, this would be even more stark if you have an aggressive risk profile where the allocation to equities is almost 78 per cent and bonds is around 8 per cent.
Why am I raising this? Well, we continue to see more flows into our income-related portfolios relative to the growth-oriented strategies. For some, this is apt. If you are well into retirement, then your portfolio is there to help finance your current expenses.
Therefore, being able to rely on this cashflow can be seen as important. Meanwhile, bonds are inherently less volatile – 2022 excepting – which can be seen as important for investors who have less time to recover from temporary losses. Therefore, some investors follow a simple rule of thumb: keeping your equity market exposure at 100 per cent minus your age. (If your age is 60, the equity market exposure is kept at 40per cent.)
‘Today, Tomorrow, Forever’ dynamics
However, we would look at this quite differently, starting with what you want to do with your wealth. We look at things through our ‘Today, Tomorrow, Forever’ framework where ‘Today’ is about your short term (0-5 years) funding requirements; ‘Tomorrow’ is about what’s important to you in the future; and ‘Forever’ is about saving for the next generation.
Let’s say you have entered retirement, then clearly you will have cashflow requirements today.
However, let’s say you are 65 years old. What is your potential investment time horizon? You probably should be planning to be financially self-sufficient until you are 100. Your life expectancy is likely lower than this, but you should be prepared for the outcome of living well beyond the average life expectancy (by definition, roughly 50 per cent of people do).
This means you have an investment time horizon of up to 35 years, roughly equal to 5-7 economic cycles. This, in turn, would suggest a significant allocation to a growth-oriented portfolio makes sense. Of course, if you are younger, or plan to use some of your accumulated wealth to fund the ‘forever’ bucket, then an even higher emphasis on capital growth is sensible.
You should be thinking equity
This brings us back to the birds analogy. The income strategy is akin to a ‘bird in the hand’ approach: ‘Give me my returns in cash quickly’ rather than over the longer term. The challenges with this approach are two-fold.
First, it ignores the risk that the invested assets may go down in price such that your capital growth is negative, making it harder to generate the income you require in years to come.
Second, if directs you to areas of the market that are likely to underperform over the long run.
I would argue that those with an investment time horizon of over 10 years should devote a significant part of their investment capital to a growth-oriented allocation. In jurisdictions where the tax rate on income is higher than that for capital gains, this tilt should be even greater.
