What if I get the worst run of returns in the worst order?

When we invest in markets, we know to expect volatility.  We also know that diversification and a long term timeframe will help to manage this volatility and give us a reward for the risk we take.

A further sub-set of this general market risk that many investors do not know about or address is sequencing risk.

Put simply, a father of 60 and son of 30, choosing the same assets for their superannuation portfolio and both measuring their average return at 8%pa over a 20 year period, will likely have very different investment experiences, due to sequencing risk.

To start in understanding this issue, consider these points:

1. When you experience a 10% loss in one year, followed by a 10% increase the year after - you are not equal.  It takes a higher rate of return to recover from a downward turn.
2. Secondly, losing 10% on a $10,000 portfolio (when you're young and uninterested in retirement) has much less impact than losing 10% on a $1 million dollar portfolio, 2 years out from retirement.  This is known as the "portfolio size effect".
3. Finally, we have to acknowledge that you regularly add to your super portfolio over time and there will be regular income you want to withdraw from your account one you retire.  These inflows and more importantly, when they occur - have an impact.

To highlight this issue, let's look at 25 years of hypothetical returns and re-arrange those annual returns to occur in 3 different orders.

If you were 40, saving for retirement over this 25 year period - your retirement savings bucket would vary considerably depending on the order in which you experienced the returns, as seen below:

  

Similarly if you were aged 65 and about to retire, your retirement bucket would last for vastly different timeframes depending on the order of returns you experienced.

Hence we are faced with a challenge.  We know that the majority of Australians do not have enough capital or money in their super bucket to park it in cash and live off the interest.  We know that having some exposure to growth assets will be necessary to ensure our funds last, but what if we get the worst run of returns in the worst order?

New rankings published by Mercer on October 15, 2012 suggest that Australian super funds have the highest share of their holdings invested in growth assets in the world.  So this suggests that we may feel the brunt of sequencing risk more than other countries.

Sequencing risk can be addressed in a strategic way that accounts for the possibility of negative returns in the last stage of accumulating your wealth (pre-retirement) or early stages of retirement.

Milevsky & Salisbury (2006) suggest that there is a retirement zone.  So if you're 40 now and plan to retire at 60 and we assume that you will live until you're 90, between the ages of 50 and 70 you could be taking a strategic approach to your asset allocation to tackle the impact of sequencing risk.  You may be relying on your super fund trustee to get this right for you, but we warn that a "default" asset allocation that you haven't chosen to suit your personal needs and objectives could be very risky.

The Association of Super Funds of Australia (ASFA) recently published this average asset allocation of "default" strategies which is between 56-70% invested in volatile, market-linked assets.

Outside of the family home, the next largest pool of assets is typically capital accumulated for your retirement.  Based on the impact sequencing risk can have, perhaps it's worthwhile having a trusted adviser show you ways to manage this.

The 4 Things Every Investor Should Know

We live in challenging times.  It has been a long time since rising markets have been so generous as to forgive the sins of a poorly constructed investment portfolio.  And it is in uncertain times such as this that it is worth remembering what we can rely on.  
With this in mind, we thought it timely to list the definitive top four investment principles that every investor should know:

1. How you allocate your investment capital across the different asset classes is by far the biggest determinant of portfolio performance.  Academic research shows that more than 90% of the long-term performance of an investment fund, is determined by its asset allocation.   Market-timing and individual stock selection are shown to have been unable to produce enough value to overcome the associated operating expenses and transaction costs of active management. Stock-pickers take note!
2. Stop thinking that you can second guess the market.  All the news, good and bad, is already reflected in the market price. Also, the probability of you being consistently smarter than the collective knowledge of all other market participants …. well, let’s just say that it is improbable.  Empirical research has found that even professional fund managers who do this for their day job have real trouble beating the market consistently.  And most don’t.
3. The best protection against volatility is diversification, both across the asset classes and within each asset class. Yes we have all heard this before – that is because it is an investment truism, so don’t break this golden rule.
4. Heads and tails … risk and return, two sides of the same coin.  When risk is high, investors gravitate toward safe assets and away from riskier assets.  The prices of riskier assets adjust downwards thereby offering a higher expected return for those assets.  This reminds us of a great quote from Warren Buffett  “Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance”.

Sorry if we are sounding like a broken record here but these are the fundamentals of a good investment strategy ..... applying them provides the highest probability of a successful investment experience.

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Image: FreeDigitalPhotos.net

One of life's lessons ...

Our 100% growth investors have had a bumpy ride, like most over the last few years, but it's very interesting to note how quickly the recovery can happen - you can't afford to miss it.

To 2nd April 2012, our 100% growth investors - diversified across domestic, developed international hedged markets and emerging markets experienced a - 6.17 % return for the 12 months.  But when you look at what has happened in just the last 92 days - they've had an 11.09% recovery.

To look at a longer period, if you invested $1,000 in the ASX 300 in June 1992 through to December 2011 - you would have achieved 8.8%pa average return - $5,232.  Not a bad average given that we've had the Gulf War, 911, the Afghan War and a GFC during that period.  However if you missed only the best 15 days in that 19 year period, because you retreated to cash when the world looked uncertain and markets got volatile, or perhaps you got concerned about what the European Debt crisis would mean for stock prices, then your average annual return would have dropped to 5.1%pa or only $2,641.

Unfortunately fear drives many investors to miss the returns that are available to them.  They're convinced that they know something that the market doesn't.  It's just not true - the market is efficient at taking all new information and factoring it into prices very quickly.  We are more globalised than ever and whilst pricing mistakes can happen, it's not as often as you think.

It doesn't help investors that most economists don't get it right either.  In the SMH/Age Economists survey on Jan 6 2008, 28 leading economists forecast that the $AUD would go up to $0.90 US cents (from 88c), the cash rate would go up to 7.5% (from 6.75%) and that the ASX 200 would go up 8% to 6800.  What actually happened was that the AUD dropped to 70 US cents, the cash rate dropped to 4.35% and the ASX 200 was down 41% to 3722.

Then in Dec 2010, the same SMH/Age Survey (21 economists) forecast the AUD down 10% - it went up 5%, forecast the cash rate to go up to 5.25% from 4.75% and it went down to 4.25% and that the ASX 200 would go up 8% to 5169 and it went down by 14.5% to 4056.

The video clip below, The Investment Answer, provides some useful insight.

The lesson is to realise that market timing will cost you more than it will save you.  Successful investing does not require a crystal ball - it requires discipline.

Trick or Treat?

Did you have children knocking on your door for Halloween on October 31st?   It seems to have become quite popular in our neighbourhood over the last few years and again this year we had a few groups of kids knocking on our door, bags at the ready.  I never say "Trick" because I don't fancy washing eggs off the front windows of my house.  So we had our stock of treats in preparation for the hungry hordes and by treats I mean chocolate and lollies, not a piece of fruit, fresh or dried thankyou very much.  I understand the whole "healthy snack" principle but if I am a kid, I'm not getting all dressed up and running around looking for fruit!

Anyway, in the spirit of Halloween, The Trusted Adviser will make a habit each year around October 31st of asking a "Trick or Treat" question about investing.  

This year, we are going to talk about a certain type of "property educator" that promotes investing in property, often, but not always, through "wealth-creation seminars".  I will kick off by quoting directly from one of these "investment mentors":

"Our earnings come through property developers.  This means we can offer our advice and support free to clients.  We are not here to "sell you a property" - we are here to help you build a property portfolio and achieve financial independence."
OK, so how much do they receive from property developers for finding you "the best investment property": 4% - 6% of the property sale price.  That doesn't sound like "advice and support free to clients" does it. You don't have to be Einstein to work out that this is all about selling a property and it is being dressed up as financial advice ....... and it certainly isn't free!  

These property investment gurus sell these development properties for a commission and their sales angle is emphasize the tax benefits.  Principally, they show the "magic" of claiming depreciation allowances to reduce your personal income tax bill.

My advice to you if ever you find yourself getting the hard sell from one of these "property educators" - remember these three things:

1. More than half of the purchase price of these development properties can be attributed to the building and yet we know that the building depreciates.  When buying investment property, you want to be putting most of your money into the land component because it is the land on which the house is built that goes up in value over time.
2. The building depreciation allowance that is being used to promote these properties is deducted from the purchase cost (i.e. cost base) when it comes time to sell, resulting in a higher capital gains tax assessment.
3. When the tax benefits of an investment are being heavily promoted, think twice about the quality of the investment.

So next time you are invited to a seminar selling development property and you are offered advice for "free", I would suggest that you give it a miss or at least take some eggs with you!  

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Image:  A Jack o' Lantern made for the Holywell Manor Halloween celebrations in 2003.  Photograph by Toby Ord on 31 October 2003.

An investment not worth paying for

When you’re making any purchasing decision, you make a judgement about whether you believe you’re getting value for money.  Along with price, other things that may come into the calculation include convenience, great service or in the case of luxury goods, the perceived effect on your social status.  

But when it comes to money management, the one factor that should not sway the decision is the promise of “great investment returns”.  As alluring as this sounds, we know that this is a very bold promise and you should know how to check if your money manager (read: stockbroker, fund manager or financial adviser) delivers.

So here is a proposition for you:
 

If these stock-picking pros promise great returns, their performance should be measured against the market in which they are investing.  If they are picking Aussie shares for your portfolio, then you should know if they are getting a better return than the market itself.  Why?  Because you can buy the market yourself at a much lower cost!

Don’t get me wrong, these stock-picking professionals are trying to beat the market.  It’s just that it is really hard to do.  You don’t want to pay extra if the result is more due to chance than skill.  And that is what the evidence from Karaban & Maguire (2011) is telling us:  

The S&P/ASX 200 Accumulation Index has outperformed approximately 70% of active Australian equity general funds over the last five years, increasing to approximately 77% over the last year (mid year 2011).  At least 69% of active international equity funds underperformed relative to the benchmark over every time horizon. Over the last year, the index has outperformed approximately 80% of actively managed international equity funds. 

So if the odds of beating the market are that bad, why would you pay more for the promise of better returns? 
 

The Trusted Adviser.

DIY Share Investing: Prudent Management or False Economy?

Now that you know a bit about us at The Trusted Adviser, it's time to ask you a question - if you are a serious do-it-yourself share investor, why are you going it alone?  For many of you, the answer will be “So I don’t have to pay management fees” or it may be about something more fundamental like trust, or a lack of it, in the advice of others.  Whatever the reason, if you are serious about managing your money (and I am guessing that you are), it is essential that you know how you are tracking compared to the performance of the sharemarket index.  Why?  How else will you know if you are doing a good job?  And if you heed this advice, brace yourself, it could be a very humbling experience.

But investing is not just about return. There is the other small matter of risk to consider.  Now you may not agree with me on this, but I reckon hanging your hat on a handful of stocks is risky

• It lacks diversification, and
• It risks significant under-performance compared to the market.

What?  You don’t care if your returns aren’t as good as the market, as long as the return is positive.  If you think that and you’re serious about making money, stop reading now.

For those of you still with me, let’s get back to diversification.

A dozen stocks sounds diversified enough doesn’t it?  And where’s the risk in owning BHP, RIO, the banks, Wesfarmers, Woolies and Woodside?   Shareholders in General Motors thought the same way before the GFC didn’t they? But I hear you saying “GM was having trouble way before the GFC and everyone could see it.  I would never have invested in a stock like that”.  Hhmmmm….Wesfarmers went from $42 to $14 as investors nervously watched them negotiate with their bankers while chewing on a gob-full of debt from the Coles acquisition.  And what about RIO?  $124 to $24 as they carried the can (and debt) from their ambitious acquisition of the aluminium giant, Alcan.

Anyway, enough tripping down memory lane.

Under-performance relative to the market costs real money and that’s ignoring your hours of research.  Wouldn’t it be just a little bit disappointing if you were getting a less-than-market return for all your time and effort?  But I really enjoy it, I hear you protest.

Well if stock picking is one of your hobbies, here’s my advice

1. Pick a relatively small sum to play with – say no more than 10% of your investment capital 
2. Take less risk with the rest (check out our post on trying to beat the market - “An investment not worth paying for”).

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Our main message here is that successful investing is about only taking risks that are likely to compensate you with added return over time.  It is best summed up by our friends at Dimensional when they say: 

Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, and speculating on “information” from rating services.  To all these, diversification is the antidote.”1

For an academic perspective on diversification, you can also view this video:

The Trusted Adviser