We have written on several occasions about the impact of deflationary expectations and Quantitative Easing (QE) on bond yields. This note discusses some broader observations of the effect this has had on asset markets more generally.

A number of clients have observed recently that returns for their lower risk client portfolios are exceeding those of their higher risk client portfolios. This has largely been driven by the huge recent run in bonds, reflecting QE and worries about deflation. Higher returns from supposedly lower risk assets seems to many observers somewhat perverse and clearly shouldn’t be expected to persist for any length of time.

A key part of our process is understanding risk. Much of financial theory considers risk as fixed – bonds are always less risky than equities and so on. We think this is an absurd point of view, risk is clearly a variable, and it is affected by real world events and, importantly, asset prices. Arguably we cannot manage future returns but we can manage the risk we take. Common sense should suggest that if you pay a high price for something your risk of loss is higher than if you pay a low price. However, most financial theory assumes prices are efficiently set by markets and, therefore, risk is static.