08 September 2011

Dear Investor,

Volatility and Lifecycle Investment

Long time readers of Investment News and students of economic history will be well and truly familiar with the concepts of "risk" and "return." Yet it seems that many investors - including professionals - have not properly thought through the consequences of these concepts.

In this edition of Investment News, we will consider some of the insights of the advocates of "lifecycle investment" in the context of recent economic volatility. Most importantly, we will examine the irreparable damage that can be caused to investors' portfolios by losses experienced in the years close to retirement and the importance of adapting our investment strategies to reflect our stage in the investment lifecycle.

The rollercoaster ride continues

August 2011 was yet was another month of extreme volatility on the Australian (and international) share markets. As chart 1 shows, the Australian stock exchange (S&P/ASX200) plummeted from close to 4,700 at the start of July to below 4,000 in early August. This drop of about 15% has since been followed by a series of recoveries and setbacks.

A truly concerning consequence of the continued volatility of share markets is that investors have now experienced over seven years of negative real returns (on average). As chart 2 indicates, an investor who went to sleep in early 2004 and woke today would find the nominal value of his or her share portfolio virtually unchanged - with the real (inflation adjusted) value declining by almost 25%.

Nothing new under the sun

Unfortunately, such dramatic declines are nothing new in Australia. Chart 3 shows some of the larger declines in the Australian stock market over the last 100 years. As can be seen, there are fifteen occasions on which the stock market has declined by at least 20 per cent, with this year's decline not even registering (yet). That equates to one crash of major proportion every six years.

Consequences for investors

Famed investment guru Warren Buffett famously said that the first rule of investing was "never lose money." He added that the second rule was "never forget the first rule." By this apparently sensible measure, the performance of shares over the last eight years has been a disaster for all investors.

However, share market crashes have an even more permanent effect on particular investors. Most especially, share market crashes have a major impact on investors who are nearing retirement. Chart 4 shows the effect of a 25% loss on a possible portfolio five years before retirement. Because the investor has the most dollars at stake in these last 'accumulation' years, the loss can destroy up to 1.5 times the investor's lifetime contributions and reduce the investor's annuity income by one-third. As can be seen, rather than paying out over 30 years post retirement, the portfolio will last just 18.

This type of disastrous outcome is what is being faced by many investors today. With stock markets apparently more volatile than ever, investors face a substantial risk that formerly healthy portfolio balances will be suddenly and drastically slashed just when they are needed the most.

The cause of this problem is volatility. Share markets are a proven and absolutely valid form of investment. But they are also a very volatile form of investment. They have the potential to produce very strong returns in some years, but they also produce very heavy losses in others, as we have already seen. An investor nearing retirement must always remember that, if their share portfolio drops by 50%, it must increase by 100% before they are even back to square one. Since share markets can take a considerable time to recover from heavy losses, investors nearing retirement can often be forced to draw from an already diminished portfolio, further compounding their losses.

What is to be done?

It is clear that this sort of risk is unacceptable to investors individually and to Australia as a whole. Former Prime Minister, Paul Keating, has joined a growing chorus of economists and investments specialists in arguing that portfolios are overly exposed to equities (shares). In a recent article in the Australian Financial Review, Mr Keating is quoted as arguing that portfolios are "too heavily weighted in equities [and] not enough in fixed interest."

"Fixed interest" investments are those in which you invest your capital and then are paid interest until maturity, when you receive your money back in full. Typically, they do not target stratospheric returns, but instead offer more stable and reliable income with some measure of capital protection. Importantly, they typically are far less volatile than share markets and can therefore form a critical part of the investment strategy of an investor in the last 10 or so years before retirement.

Whether you are nearing retirement, or simply want to balance your investment portfolio with increased exposure to an asset class with different performance characteristics to share markets, fixed interest should be an important part of your investment strategy.

Best regards,
Chris Andrews

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Chris Andrews
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