Putting negative investment returns in context

- AMP Capital Investors


The major international theme for the June quarter was an easing of credit-crunch fears being replaced by concerns on inflation as oil prices climbed to new highs. The threat of rising inflation at a time when economic growth is slowing spooked investors, which led to a renewed bout of weakness in share prices and ongoing volatility in financial markets in general.

The situation for investors is made worse by uncertainty surrounding the outlook. We think the outlook for the next few months is messy - with oil now the key - but that shares have seen the bulk of the damage. Shares should be back on to a sustainable rising trend later this year as oil prices eventually fall, and investors look forward to better conditions ahead and start taking advantage of attractive share valuations. There are, however, no end of experts who are saying the bear market has only just begun.

Given the uncertainty of the times, it’s useful to put things into an historical context.

Shares and Diversified Funds

All things considered, the recent losses in diversified fund values should not come as a surprise to those who have shown an interest in their investments and have sought advice. The key driver of returns for an investment portfolio is the asset classes in which the funds are invested. The most common medium-risk diversified funds have 60% of their funds invested in growth assets (for example shares and property). This also applies to many individual investors’ separately managed portfolios. The logic behind this allocation is that, over the long-term, growth assets provide higher returns.

Over the last few quarters shares have fallen sharply on the back of the sub-prime mortgage crisis in the US, the credit crunch and more recently the surge in oil prices. From the October peak to the recent trough, US shares plunged 22%, New Zealand shares lost nearly 30% and globally shares fell 23%. Over the year to June, the generally positive return in other assets has not been enough to offset falls in listed assets and so investment portfolios with a bias towards growth assets have declined in value.

Negative Returns are Not That Unusual

The most important thing to note is that periodic negative returns from a diversified mix of assets are normal. Of course, for new investors it may seem unusual when returns have been relatively stable and favourable over recent times, as was the case from mid-2003 to mid-2007.

Chart 2 shows a simulated performance of a balanced fund over a very long period of history. The simulated fund is composed of 60% shares (20% domestic/40% international), 35% bonds (20% domestic/15% international), and 5% cash. Property exposure is not included because long-term historical data is not available, and the international investments are left unhedged (but expressed in New Zealand dollars) for simplicity. The numbers have also been adjusted for inflation so they equate to real spending power in today’s dollars.

Chart 2:


It’s clear that periods of negative returns in a balanced fund are a normal part of the investment cycle, as are subsequent recoveries. The main driver of negative returns is typically declines in share markets, often associated with economic recessions. For example, negative returns occurred in 1931-32 (Great Depression), 1937-38 (US recession), 1941 (World War II), 1944-46 (recession), 1948-49 (recession), 1958, 1962, 1966-67 (recession), 1970 (US recession), 1973-74 (oil crisis, stagflation), 1987-88 (share market crash), 1990 (recession), 1994-95 (bond crash), and 2001-03 (tech wreck, terrorist attacks).

In the midst of these it probably seemed like the “worst ever crisis”, but shares always recovered to resume their rising trend, pushing investors’ returns back into positive territory. With shares and growth assets, periodic negative returns are the price we pay for the higher long-term returns they provide on average. Indeed, it is useful to remind ourselves of those higher than average returns whenever we get an occasional set-back. For example, AMP Capital Investors’ medium-risk balanced fund generated double digit rate of returns over the 2002-2006 period (14.1% pa in nominal terms and 11.3% pa in real terms). While the average balanced fund investor may have lost a nominal 5% or so over the last year, the previous four years to 2006 would have seen their savings grow by around 45%.

Switching To Cash is Likely to Reduce Long-term Returns

It is also useful to remind ourselves about the pitfalls of overreacting to a loss. After a loss, it’s tempting to switch to a more conservative strategy. But, this will just lock in the loss and will invariably result in lower longterm returns. Chart 3 shows the cumulative return to two portfolios since December 1930:

• The balanced fund noted earlier with fixed weights (40% global equities, 20% NZ equities, 20% NZ bonds, 15% global bonds, and 5% cash).

• A “switching strategy” that starts off with the balanced fund mix, but moves 100% into cash after any negative calendar year and doesn’t move back until after the balanced portfolio generates one calendar year of positive returns. This replicates an investor who switches to cash after a down year, and requires a year of positive returns to get confident again (or to regret being out of the market).

Chart 3 clearly depicts the difference between the two strategies. Over the entire period (from Dec 1930 to June 2008) the switching strategy produces an annualised real rate of return of 3.1% pa versus 4.2% pa for the balanced fund. That may not seem much, but in terms of real spending power, a $100 investment in 1930 would have grown to $1,076.56 by June 2008 for the switching portfolio, versus $2,354.34 for an investment maintained in the balanced fund. The conclusion is clear - switching to cash after a bad year of investment performance is not the best strategy for meeting one’s savings goals over time.

Chart 3

Psychology Through the Cycle and Longterm Investing - “Know Thy Self” Helps

Generally retirement savings and investments in growth assets have to be seen as a long-term proposition. Of course, when retirement is near, the portfolio should naturally revert to lower risk to avoid the chances of losses that can no longer be recovered over the remaining short period of investment. Having all of one’s savings in cash may make for a good night’s sleep at times, but given its lower long-term return potential it’s unlikely to provide enough for a decent retirement. Yes, returns on cash are now quite high, but they are unlikely to be sustained. The rapid slowdown in the domestic economy, along with the easier monetary policy which has now begun means the returns from cash will no longer be such good value.

One of the key ingredients for successful investing is for an investor to be aware of how their psychology is being affected by movements in investment markets. Typically, investors tend to be “despondent” after a period of strong falls in the value of their investments. This results in selling or “capitulating” at the bottom of the investment cycle when in reality the opportunities for capital gain are at their greatest. Given the difficulties in timing though, for most investors the best approach is to adopt an appropriate long-term investment strategy and to stick to it.

Conclusion

No one likes to see their investments fall in value. But occasional bouts of negative returns are the price we have to pay for the higher returns growth assets provide over time. Switching to cash may make sleeping at night easier when markets are falling, but it’s likely to ensure lower long-term returns. The key is to adopt an appropriate longterm strategy and to stick to it.

Top tips for investing during volatile times

1.    Stick to the investment strategy
Once investors have worked out a suitable investment strategy with the appropriate degree of return versus risk for their investment timeframe, it’s important to stick with it through the inevitable ups and downs of investing. History has shown us that responding to negative returns by switching to cash tends to lead to lower returns over the longterm. Don’t buy high and sell low!
2.    Understand your investment psychology
One of the essential ingredients for successful investing is for an investor to be aware of how their own psychology is being affected by movements in investment markets to which they are exposed. Investors will have to be very honest with themselves about their own appetite for risk and their psychological capacity for bearing short-term losses to allow their savings and investment strategy to work for them. Investors should undertake a risk profile checklist to understand which investments will work best for them through thick and thin.
3.    Invest in quality assets
During times of volatility it’s prudent to be cautious, move away from speculating too much and invest in quality assets. However, if you invest in a managed fund you can safely assume that the manager is undertaking that on your behalf.
4.     Don’t try timing the market
Trying to time the bottom of an economic cycle is impossible. The best approach for long-term investors is to sit tight. For those wondering when it is time to buy shares, the best approach is to average in rather than attempt to predict the precise bottom in order to limit the impact of getting in too early (or too late).
5.    Seek professional advice
Financial advisers, and the investment industry as a whole is under media scrutiny at the moment, but particularly during these volatile times and with the introduction of KiwiSaver and PIEs, investors need well-informed, good and honest financial advice.