Recent headlines:

The Reality of How Investment Markets Work

Posted by Scott Keefer on Sep 5th, 2008

Reality 1 - Growth Assets Such as Share Investments and Property Investments are Volatile

There are two groups of investments used in portfolios. The first are ‘defensive’ investment assets which include cash and high quality fixed interest investments such as Australian government bonds. The second group is generally referred to as ‘growth’ investment assets such as property and shares (both Australian and international). The returns from these asset classes are volatile. In the last 30 years:

Annual Australian Share Returns have ranged between -29% (1982) and 74.3% (1980)
Annual Global Share Returns have ranged between -23.5% (2002) and 72.7% (1983)
Annual Listed Property Returns (Aust.) between -36.3% (2008) and 41.3% (1987)

(Year to 30 June, Vanguard Investments)

Reality 2 - Growth Assets Have a Higher Long Term Expected Return

Given that a good cash account provides a rate of return of above 6% in the current environment, why would you invest in growth assets at all? The answer to this is that growth assets have a significantly higher expected return than a cash or fixed interest investment.

Average Australian Sharemarket Return since 1970 11.3% a year
Average Global Sharemarket Return since 1970 10.7% a year
Average Listed Property Return since 1987 10.1% a year
Average Cash Rate of Return since 1970 9.3% a year

(Year to 30 June, Vanguard Investments)

Reality 3 - Volatility CANNOT be Avoided

Wouldn’t it be great if we could avoid the down times of investing in shares and property, and only invest in them when they are increasing in value? Well it would be good, however it does not happen. As an example, let’s look at the biggest crash in recent Australian investment history, the 1987 sharemarket collapse where shares fell in value by more than 30%. Just prior to the 1987 collapse, more money that ever before was invested in the Australian sharemarket. The collective wisdom was that this was a better place than ever before to invest money. The collective wisdom was absolutely wrong, as the sharemarket fall showed.

Dalbar, a US financial services firm looks at the actual return investors in the US received from their managed fund investments. Over the 20 years to the end of 2007 they found that US managed fund investors received a return of just under 4.5%, against a market average return (S & P 500) of 11.8%. Why did managed fund investors receive such a terrible return? Because they were trying to pick and choose when to invest and therefore avoid volatility - which seriously damaged their ending investment returns.

Reality 4 - Growth Assets CAN Have Negative Periods of 5 Year Returns

The collective wisdom in the financial services industry is that if you hold a growth investment for 5 years then you will get a positive investment return. This is easy to disprove - currently most global share investments are showing negative 7 year returns.

Reality 5 - Asset Allocation and Careful Income Planning is your Key Tool in Managing Volatility

Using a mix of growth assets in a portfolio, including Australian shares, global shares, listed property trusts, global listed property trusts and emerging market funds, smoothes - but does not eliminate - the volatility from growth assets. Setting aside a number of years worth of cash needs in fixed interest and cash investments means that you will not have to sell growth assets in a market downturn. Cash and fixed interest investments, which do not rise and fall along with the general market, also dampen the volatility of an overall portfolio. The cash and fixed interest investments are replenished by the growing stream of dividends and distributions from the growth assets - eliminating much of the need to sell growth assets at any time.