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Real Returns May Likely Suffer Judging from What the History Of Returns Tell Us

Every year, Credit Suisse would update their database of annual global returns and compile them into the Credit Suisse Global Investment Returns Year book. The 2022 compilation was out not too long ago and I reviewed the summary edition.

A long history of returns, would allow us to understand how returns are through different periods of technological booms, depression, recession, economic boom, war, high inflationary, low inflationary, financial stress.

In some cases, they have data going back to 1872.

Many of you may wonder that this period is “unprecedented” or have never happen in the past and so how are we suppose to structure our portfolio in light of new developments.

I would wonder if what we experienced today is really very different from the past 120 years or so.

There were periods where we have very low interest rates and the interest rate has to rise. The evidence of history may help us understand what we will be going through.

Here are some interesting parts that I picked out.

Average Inflation in Different Countries were Much Higher Historically.

The table above shows the data on inflation in different countries.

The seven high inflation countries are Germany, Austria, Portugal, Finland, France, Japan and Spain.

Germany, in particular, has a very, very high inflation rate. The figures in this table are already controlled. If we include the 1922 to 1923 hyperinflation, the 122-year arithmetic means the inflation rate would be 1.7 billion per cent.

The average inflation rate is high. We may have been conditioned by what happened in the past decade that inflation is not an issue but with historical data going as far back to 1900, we are quite sure what happened in the future would be somewhat similar to the past.

This means it is possible that higher inflation is upon us.

How are bond and equity returns if inflation averages differently?

Bonds and Equities Do Not Hedge Very, Very High Inflation Very Well

In the diagram above, we compare equity and bond real returns with inflation in the same year, for the full range of 21 countries that have a 122-year history. They do exclude the hyperinflationary years of 1922-23 for Germany and 1921-1922 for Austria.

They broke up 2,558 country-year observations into different inflation quartiles. The bars show average real returns on bonds and equities.

The results suggest that the correlation between real equity returns and inflation is negative. This means equities have been a poor hedge against inflation.

If inflation averages 7% a year for the duration, the equity and bond returns will really suck. We better hope inflation averages lower than 4.1% a year.

Equity and Bond Returns Were Much Poorer During Interest Rate Hikes

Historically, the real returns on stocks and bonds have been much lower when interest rates are hiked than when they were eased.

The researchers measured the returns when the markets were in a rate raising and rate easing.

We can observe that when the rates were eased the returns were much higher, whether it is in the UK or in the US. The annualized premiums disappears when the rates were raised. Real returns mean that the stock returns are still there, but inflation might be higher as well (which make sense as the central bank usually raise interest rate to reign in spending).

The rewards for those practicing factor investing strategies is also lower.

The data does showed relative outperformance from

  1. defensive versus cyclical stocks
  2. large versus small-cap stocks

The Volatility is Lower During Rate Rises than Rate Fall, but the Risk versus Reward is Weaker

As we can see, the annualized volatility seemed to be higher when rates were falling than rising but only slightly. The Sharpe ratio, which measure the returns per unit risk, were much lower when interest rate rising than when they were eased.

With all these data, the history of returns in different markets do tell us to be cautious with any of our forecast. Our current results are above long-term averages spanning different economic conditions.

But within each cycles, there are considerable differences:

  1. In 40% of US hiking cycles, equities perform better than during eaasing cycles before the hiking.
  2. During the last two hikes from Jun 04 to Sep 07 and Dec 15 to Jul 19, US and global stocks and bonds performed well.

Why do we diversify our stock and bond investments?

The chart to the left shows the average risk of portfolios, using standard deviation as a measure, of portfolios containing different number of stocks.

Diversification reduces the risk rapidly at first, than slows down.

These portfolios are more equal-weighted but in real-life some of our portfolios are more value-weighted. The research shows that value-weighted portfolios have higher amount of risks that can be diversified away.

The chart on the left shows that maybe holding 10 stocks achieve the same effect as holding 25 stocks, but the chart on the right shows that by holding a lot more stocks we are able to reduce the residual risk of the portfolio even further.

For US-Centric Investors, Diversifying Across Countries May Not Reduce the Portfolio Volatility More

If our goal of investing internationally is to reduce the volatility of the portfolio, can we achieve it by investing internationally? The study first look at things through the lens of the US investor. Investing internationally exposes you to stocks which are more volatile than the US, but if you hold more as a portfolio, the standard deviation approaches that of the US.

Holding international stocks based on cap-weighted reduces the US-centric portfolio volatility more, which may be a point against investing in international small cap.

Adding International Stocks for a US-centric Investor Do not Improve the Returns per Unit Risk

The Sharpe ratio measures the returns per unit risk. The higher the better.

From the chart above, investing globally does not help the US-centric investor achieve a better return for the risk taken. Hedging the currency risks (the very light green bar) does help if we viewed from a longer time frame.

This is a point against international diversification for the US-centric investor.

US is the Uncommon Country where International Diversification is Less Useful. For Investors In Other Countries, International Investing is Better

But what if you are an investor living in different countries? Would international investing be better?

For most of us it would.

The chart above show the increase in Sharpe ratio we can gain from being global rather than domestic. Majority is above 0, which means international investing helps.

USA, together with 8 countries are the rare few that the investors would be better if they stay domestically.

Correlations between Countries have Gone Up Dramatically Post-Bretton Woods

How much risk we can reduce through global diversification depends on the correlation between the returns of different countries.

In the chart above, they show 6 different pair of country correlation, broken down into different time period buckets.

6 out of those 8 buckets show mainly positive correlation but it is only after 1971 that we see the correlation between countries to be much higher.

But it is important to note that it is the magnitude of correlation that is important than the direction of the correlation coefficient. This reduces the effects of global diversification. In the last 20 years the correlation is just so high!

Correlation between countries were much lesser before 1971.

This does suggest that post-Bretton Woods, correlations became much tighter and have been increasing.

Perhaps some events would change this…

International Diversification Benefits Stronger for Emerging Market Investing.

If we are able to break the analysis to review developed markets and emerging markets, we are able to see that the international diversification benefits are stronger if you are investing in the emerging markets. The correlation between developed markets are higher than emerging markets.

The author wishes to point out that while the case for diversification from a volatility reducing angle seems weak after we review this data, we should also be aware that by investing internationally, we are able to expand our opportunity set or the type and quality of companies we invest in.

A portfolio of 50% Stocks and 50% Bonds Gives You a Portfolio that is Easier to Live With

The diagram above shows the real drawdown (after inflation) of a 50/50 US and UK stock and bond portfolio.

Credit Suisse mention that there were periods where equities and bonds lost more than 70% in real terms.

But since 1900, the 50/50 blend of portfolio in US and UK have not lost greater than 50% of its value.

The most important thing is: The duration of the drawdowns are briefer for a blended portfolio than if you invest in a supposedly low-risk fixed income asset.

Correlations Between Stock and Bond Across Different Countries Tends to Be Positive Over Time. The Last 20 Years Were Very Unique

Stocks and bonds work well with each other because of the low correlations. If we maintain our discipline to rebalance them, we are able to systematically buy low and sell high. (aside from having a portfolio that is closer to your risk tolerance)

But from the history of returns, there were periods where the correlations are quite high (above 0.5).

In the past 20 years, the correlation between bonds and equity have been negative, and may condition to make us think that this is the norm.

This is not just in US, but across different markets.

It is important to stress that it does not mean if the correlation is positive, diversifying across stocks and bonds is useless. A low correlation is still pretty useful but perhaps does not “smooth out the volatility” better than if the portfolio is negatively correlated.

IF we disect by countries, most countries show a positive stock and bond correlation, and most countries show that in the past 20 years, correlations have been negative.

The exception is Portugal, Italy, Belgium and Ireland. Three of those countries were greatly affected by the Eurozone crisis in the early 2010, where there was bank solvency risks and the potential sovereign default negatively affect both bonds and equities.

How Big is The Impact Of Positive Stock and Bond Correlation On Portfolio Construction?

The stock-bond correlation plays an important role in institutional portfolio construction. It is central to forming optimal portfolios, designing hedging strategies and assessing risk.

Stock-bond correlations have now been negative in most markets for the past 20 years.

This means stocks and bonds hedge each other very well, and it enables investors to increase stock allocations while still satisfy a portfolio risk budget.

The team analyzed the impact of different level of stock-bond correlation on the portfolio risk and Sharpe ratios. They assume an expected annualized real return of 0.5% for bonds and 4% for stocks.

The chart above shows the impact on volatility and Sharpe ratio if we change the stock-bond correlation.

Suppose we want to create a portfolio where the standard deviation is only 10% (low risk). When the correlation is -0.3, the low risk portfolio can be a 52% equities 48% bonds mix.

If the correlation rose to 0, the stock allocation will need to fall to 40% to still meet that 10% risk budget. By having less stocks, the expected return of the portfolio will go down from 2.31% a year to 1.9% a year.

If the correlation rose to +0.3, the equity allocation would need to be reduce to 21%, which would reduce the expected return to 1.24%.

The history of returns tell us that if correlation goes up, portfolio managers have a hard time controlling risk and still achieve the same returns.

They might have to be more fancy in their allocation.


I think living in the past two decades may have lured my brain into thinking that stock and bond relationship is negative.

This summary is a timely recalibration of what I remember about finance.

If inflation does not stay in control, equities and bonds is not going to do well. From other research, the best inflation hedge during those very, very high inflation period have been short-term treasury bills of the countries (and not so much commodities and those assets surprisingly).

I was surprise historically volatility have been lower during interest rate rises than fall. This may be due to a couple of articles casually pointing out the volatility tend to be higher when interest rate is higher.

I think there is a different between higher interest rate environment and rising interest rate and the article relates more to the latter. This make sense in that you raise interest rate to control growth and you would usually do that when things are more stable.

The history of returns tell us that if you deviate from the US market, your returns are poorer. This gives justification to only focus on US market. If you are an international investor, having a global portfolio may be better for you than just be home-country centric.

Finally, the correlation between bonds and equity traditionally have been low positive. If correlation regime swings back to the past, with the current low returns, it means your current portfolio setup might be more volatile (if you are currently holding a stock and bond portfolio). To reduce the portfolio volatility, you might need to hold more bonds, but that would blunt your returns.

This is not an easy situation to navigate sadly if you are a risk-averse investor.

I invested in a diversified portfolio of exchange-traded funds (ETF) and stocks listed in the US, Hong Kong and London.

My preferred broker to trade and custodize my investments is Interactive Brokers. Interactive Brokers allow you to trade in the US, UK, Europe, Singapore, Hong Kong and many other markets. Options as well. There are no minimum monthly charges, very low forex fees for currency exchange, very low commissions for various markets.

To find out more visit Interactive Brokers today.

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Wednesday 16th of March 2022

Too bad the summary doesn't include performance for real estate or other alts like fine art & collectibles. Suspect property/Reits may do ok in high inflation periods if can hold thru the volatility.

Am surprised the chart showing global diversification for various country investors indicated a worse Sharpe ratio for hedged portfolio for a S'pore-based person. Would have thought that SGD is one of the stronger & better managed currency.

This is a comparison of Permanent portfolio versus 50/50 from 1972-1982. Had to replace Long Term Treasuries to Intermediate in order to get the data back to 1972.

The interesting part is the bar chart annual returns.

You can compare against the same time period for Inflation and Effective Fed Funds rate.


Wednesday 16th of March 2022

Thanks Kyith, very informative post. This actually made me think, is delayed gratification always justified, considering, we can have scenarios like you mentioned of very very high inflation, so stuff we are postponing to buy/experiences we are postponing may cost much more in the future and our portfolios may not even keep pace. While the best hedge against inflation, is actually to just stay employed. Wages typically get adjusted for inflation.

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