Mark & Julie Keenan |
Strategy Summary - 23 July 2017 |
Investment Strategy - Our Approach
Long-term, the approach you take to investing your assets is one of the primary determinants of how long your capital will last. If you take too much risk then you could be wiped out in a market crash; take too little risk, and your investment earnings will fail to keep up with inflation and you will slowly but surely see your savings disappear.
There are a wide range of factors to take into account. In the discussion that follows I will touch on a few of the most important.
There are a wide range of factors to take into account. In the discussion that follows I will touch on a few of the most important.
1. Investment Structure
Your investment structure refers to the way your assets are organised from an ownership perspective. For example, which assets are held in Mark's name, which in Julie's name, and which within superannuation (which, from an ownership and tax perspective is separate). This is also where we consider whether things like Trusts or companies might be used. Usually the driving force behind these decisions is tax, asset protection and asset distribution. Put simply, we want to (a) reduce the amount of tax you need to pay, (b) make sure your assets are protected in the event of legal problems, and (c) your assets are managed and distributed in accordance with your wishes (this has particular relevance from an Estate Planning perspective).
A simple example: if you wanted to invest $3m, evenly spread across high-growth shares, unlisted property, plus a portfolio of shares for your kids, you would probably look to invest in the shares via super (to mitigate tax at sale), while unlisted property might be held directly (as the tax deferral credits would probably mean you would avoid paying tax on earnings, and you might spread the kids money across a range of smallish Investment Bonds (to reduce tax).
A simple example: if you wanted to invest $3m, evenly spread across high-growth shares, unlisted property, plus a portfolio of shares for your kids, you would probably look to invest in the shares via super (to mitigate tax at sale), while unlisted property might be held directly (as the tax deferral credits would probably mean you would avoid paying tax on earnings, and you might spread the kids money across a range of smallish Investment Bonds (to reduce tax).
2. Investment Platform
When we talk of "investment platform" we are referring to the product in which your assets are held or managed. This might be a super fund, such as Australian Super or a SMSF, or through an investment wrap, or simply in your own name. It’s important to get the structures and platforms right as we want to make sure there is sufficient flexibility to do what you need it to do, while keeping costs down. For example, if you wanted to trade shares or invest in private equity, your options will be much more limited than if you were happy holding index funds or multi-asset funds.
I emphasise that it is very important to be conscious of fees. Quite simply, it is not possible to increase returns without increasing risk. Risk has many connotations, but for now I would like you to think of it as this: if in order to generate an additional 0.5% of return we need to increase our portfolio volatility by 1.0%, then by choosing an investment structure that is 0.5% more expensive we are increasing our net downside risk (lower range of expected returns after fees) without getting any additional upside potential. There are times where we need to pay a bit extra for things - for example, getting access to limited private equity issues or hedge funds - but where we can get the exact same thing at a lower cost we should almost always opt for the cheaper option.
I emphasise that it is very important to be conscious of fees. Quite simply, it is not possible to increase returns without increasing risk. Risk has many connotations, but for now I would like you to think of it as this: if in order to generate an additional 0.5% of return we need to increase our portfolio volatility by 1.0%, then by choosing an investment structure that is 0.5% more expensive we are increasing our net downside risk (lower range of expected returns after fees) without getting any additional upside potential. There are times where we need to pay a bit extra for things - for example, getting access to limited private equity issues or hedge funds - but where we can get the exact same thing at a lower cost we should almost always opt for the cheaper option.
3. Investment Selection, Part 1: Strategic Asset Allocation (SAA)
It is estimated that between 92% and 97% of investment returns are explained by your asset allocation decisions (commonly referred to as Strategic Asset Allocation). By this we mean the way in which we allocate investments across different classes of investments; classes are things like Australian shares, AREITs, Government Bonds etc…
In focusing on these Strategic-level decisions we will miss out on “opportunities” in other areas; this is inevitable. But our focus should always be on getting this 92% (or 97%) right. We would prefer to pick an average performer from a group of winners than the top performer within a group of losers.
In focusing on these Strategic-level decisions we will miss out on “opportunities” in other areas; this is inevitable. But our focus should always be on getting this 92% (or 97%) right. We would prefer to pick an average performer from a group of winners than the top performer within a group of losers.
4. Investment Selection, Part 2: Tactical Asset Allocation (TAA)
The remaining 3% - 8% or so of returns not explained by Strategic Asset Allocation (SAA) is attributable due to investment selection decisions (commonly referred to as Tactical Asset Allocation, or TAA). This is along the lines of choosing whether to invest in BHP or RIO, WOW or WES etc… Tactical asset allocation can add value (particularly if we are using if for risk management), but we should not kid ourselves into thinking that good tactical asset allocation can make up for poor strategic asset allocation. However, active TAA is expensive to administer, increases taxes, brokerage and buy/sell spreads, and can increase portfolio risk by increasing portfolio concentration and fluctuations in foreign exchange exposures.
It is also worth noting that the majority of ongoing investment manager/adviser fees are charged for tactical asset allocation. This is largely due to the amount of work required to manage tactical tilts, as it often requires daily monitoring of the portfolio, market and economic conditions to be effective. This is fine for large institutional investors (say, $250 million+) where management fees might be as low as 0.1%, but for smaller accounts it’s hard to justify. We use tactical asset allocation, but slightly differently to the way most asset consultants do; we focus on sector and geographic tilts, not company tilts, and with a much greater focus on after-tax absolute returns.
I am happy to discuss further, though we will only offer this as an ongoing service if I am confident it can add significant value.
It is also worth noting that the majority of ongoing investment manager/adviser fees are charged for tactical asset allocation. This is largely due to the amount of work required to manage tactical tilts, as it often requires daily monitoring of the portfolio, market and economic conditions to be effective. This is fine for large institutional investors (say, $250 million+) where management fees might be as low as 0.1%, but for smaller accounts it’s hard to justify. We use tactical asset allocation, but slightly differently to the way most asset consultants do; we focus on sector and geographic tilts, not company tilts, and with a much greater focus on after-tax absolute returns.
I am happy to discuss further, though we will only offer this as an ongoing service if I am confident it can add significant value.
5. Building Portfolios using Asset Liability Matching
I apologise in advance for the length of this chapter. Asset Liability Matching, of ALM, is a technique which is simple (and logical) in nature, yet very rarely used by traditional advisers and asset consultants. In some ways it's a lost science. Over the past 20 years or so it has all but been replaced by the wonderfully elegant (but sadly very fragile and poor performing) models such as the Markowitz Portfolio Optimiser. You may like to skip over this section (I will try not to take offence), however, if you do perseve and come across anything that you either don't understand or would like more information on, please don't hesitate to ask.
I am an advocate for developing portfolios using an Asset Liability Matching (ALM) Framework. At its most basic level, ALM seeks to work out how much you need to put aside to pay for an expense at some point in the future.
For example, if you have a holiday planned in 5 years, or a new caravan in 2 years, or one of your children’s weddings 10 years, how much do you need to put aside to fund it? Once we know when the expense is due and how much it is for, and we understand your tolerance for investment risk, ALM assists us in working out what the optimal portfolio is for each of these expenses.
To describe how this works, let’s say you want to buy a new boat in 15 years time. You expect it will cost about $40k (in today’s money). You want to know how much to set aside some money now to fund it, with a 95% degree of confidence that there will be enough by the time you come to buy it. We then estimate that “risky” assets, like shares, are going to return about 5.2% above inflation (with volatility of +/- 10%) while “defensive” assets like cash will only get you 0.5% above inflation (with volatility +/-0.5%). From this we can calculate that an optimal investment allocation at the 15-year mark would contain about 95% risky assets and 5% defensive assets, generating an average first-year return of about 5.0% above inflation and requiring an investment today of $27,000 (Note that 5.0% p.a. over the full 15 years would only require an investment of $19,240; the reason we need to allocate more than this is that as we get closer to the point of buying your boat, we reduce our risk allocation).
By treating each of your future expenses as a future liability we are able to form a portfolio that most accurately reflects your future goals.
For example, if you have a holiday planned in 5 years, or a new caravan in 2 years, or one of your children’s weddings 10 years, how much do you need to put aside to fund it? Once we know when the expense is due and how much it is for, and we understand your tolerance for investment risk, ALM assists us in working out what the optimal portfolio is for each of these expenses.
To describe how this works, let’s say you want to buy a new boat in 15 years time. You expect it will cost about $40k (in today’s money). You want to know how much to set aside some money now to fund it, with a 95% degree of confidence that there will be enough by the time you come to buy it. We then estimate that “risky” assets, like shares, are going to return about 5.2% above inflation (with volatility of +/- 10%) while “defensive” assets like cash will only get you 0.5% above inflation (with volatility +/-0.5%). From this we can calculate that an optimal investment allocation at the 15-year mark would contain about 95% risky assets and 5% defensive assets, generating an average first-year return of about 5.0% above inflation and requiring an investment today of $27,000 (Note that 5.0% p.a. over the full 15 years would only require an investment of $19,240; the reason we need to allocate more than this is that as we get closer to the point of buying your boat, we reduce our risk allocation).
By treating each of your future expenses as a future liability we are able to form a portfolio that most accurately reflects your future goals.
A few things to note:
(a) First, from this process the portfolio generated reflects what is needed (given the inputs of return, volatility etc), which, of course, means it may require more or less than you have available. If you have excess capital, this can be used to reduce your overall portfolio risk (ie, invested very cautiously; cash buffer etc) or can be invested aggressively to maximise returns (normally for the benefit of your beneficiaries). There is no right or wrong way to use excess cash. It really comes down to your objectives and risk appetite. If you have insufficient cash then you will either need to reduce your expenses, or be prepared to increase risk which will inevitably reduce the stability of the ALM model. For example, if you have $900,000 but the original model tells us you need $1m to meet all future liabilities with a confidence level of 99% (i..e, 99% chance of success, 1% chance of failure), we might need to increase our exposure to risk assets, but this may mean our chance of failure increases to 10%. Note that I said may mean our chance of failure increases. Talking about probability of success or failure in binary terms doesn't tell us anything about the range of outcomes. In the example above, a 99% chance of success might have carried with it a 1% chance of missing the mark by $50,000, while under another scenario we might arrive at a 99% probability of success but with the risk of falling short by $500,000. ALM, by design, seeks to narrow the range of results.
(b) Over the long-term the overwhelming majority of the price increases in property can be attributed to inflation. In fact, even in Australia (which has the strongest performance of any country over the past 100 years), prices have only increased by about 0.9% p.a. above inflation. While rental income has lagged over the last 30 years, long term we should expect it to also track inflation, and possibly out-run inflation in the short to medium term. As such, for the purpose of allocating assets to future expenses, we can focus attention on your cash flow needs after taking into account rental income (i.e, if you need $70k p.a. and rental income is $35k p.a., then we only need to set capital aside to fund $35k p.a., plus a buffer for times of unexpected expenses and vacancy).
(c) The reason we don’t see many advisers or asset consultants using ALM frameworks is that they are notoriously difficult and expensive to manage. The fall from grace of traditional ALM is largely due to the large-scale bankruptcy of (mainly US) Defined Benefit Schemes. Think about the example of your boat purchase above. Now clearly if we made the assumption that returns were going to be 7% p.a. above inflation and not 3.5% p.a. above inflation we would need to allocate a lot less toward your future boat purchase (in fact only about $18k). Now, if we allocated $18k but returns were only 3.5% p.a. we would only have $30k after 15 years; so we would be $10k short. This is what happened to many large Defined Benefit funds. They thought that future returns would be higher than they were, which meant that the amount they set aside was much, much less than they actually needed. The result is that when it came time to pay the future expense they didn’t have enough money.
In this real-world example, it wasn’t a boat they needed to pay for, it was peoples’ retirement pensions. As they didn’t have enough money to pay everyone they owed they went bankrupt and people were left without the retirement income they were promised. Regulation in Australia provides much better protection for consumers, but as this example illustrates this is one of the reasons that Defined Benefit funds have fallen out of favour globally. That aside, it is a very good way of making asset allocation decisions; you just need to be very careful to get your return expectations right! (so there you have it; a lesson in the history of ALM!).
(d) A continuation of above, regarding costs of ALM. I mentioned that ALM is difficult and costly. This is generally the case, however if you are doing it just for yourselves it needn’t be. One of the reasons ALM is so tricky and expensive to manage is that normally it is used by large Pension funds, where they need to factor in a very wide range of "unknowns" (variables), including peoples' planned and unplanned retirements, different levels of contributions, number of employees, workplace liabilities (like work injuries), just to name a few.
When planning ALM for your own situation most of these variables don't apply. Instead our focus is on getting the investment risk budget (exposure to volatility and investment risk) right. As a result, a review and rebalance every 12 - 18 months is usually more than enough to keep things on track. Keep in mind that while we might determine that the optimal allocation is, say, 7% Australian equities, 13% North America (etc etc), this does not mean that a rebalance is necessary if you wake up one day and it’s moved to 5% Australian equities and 17% North America. Generally speaking you want to minimise the amount of trading that you do (excess trading erodes returns through increased taxes, brokerage and buy/sell spreads).
(e) For many people the idea of allocating money now, for expenses that aren’t due for 10 or 20 years into retirement feels very strange. An alternate way of thinking about it is to take the perspective of an investment Trustee (that is, you are responsible for managing the capital on behalf of someone else).
Example: Let’s say you have an agreement with someone, let’s call him Dave, whereby you will pay Dave a pre-agreed sum in the future. You are given a pile of cash today, but it is insufficient to pay all the future expenses that you must pay to Dave. If the money runs out that’s too bad; you still need to pay Dave, even if this means digging into your own pocket. This may mean you need to sell your assets/home etc. You work out that you need an average return of about 4% p.a. to meet all expenses. If you simply invest in a portfolio that you hope will return 4% p.a. then you may or may not have enough to meet all future expenses, and if the markets take a fall during the first few years you might be left very short.
If, however, you used an ALM framework you would be less sensitive to market risk during the early years and more sensitive in the later years, allowing you to have a greater exposure to risky assets in the early years (when we are a long way from actually needing to fund the expense), and less exposure as we get closer to D-day. The reason this works is that risk (volatility) is mean-reverting, meaning the proportionate benefit of compound returns increases over time, while proportionate risk reduces. This is because, mathematically speaking, against a normal distribution of returns volatility increases at the square-root of time. In other words, 1-year volatility of 5% will be expected to grow to about 10% over 4 years, 15% over 9 years, and 25% over 25 years. This, in turn, is equivalent to annualised volatility of 5%, 2.4%, 1.6% and 0.90%. This is one reason why it is often easier to make more accurate long-term return forecasts than short-term forecasts. One of the really interesting things about this approach (and the mathematics behind ALM) is that you end up with a portfolio that classifies risk differently to traditional portfolio theory.
A really good example is something like the way that Bonds are priced:
Bonds are issued by companies (or government) to raise capital. They do this by agreeing to make a repayment to you (the prospective lender) at a fixed price, at a fixed point in time (say, 10 years from now). Regardless of whether they pay "interest", Bonds are essentially priced the same way: the current value of the Bond is equivalent to the present value of all future payments to you, from today until maturity. For an ALM investor, if someone has a future liability of $100 due on 1 January 2020, they can buy a Bond with a face value of $100 and maturity date of 1 January 2020 (the price of the Bond will depend on few factors, but is usually linked to the yield curve and risk associated with the Bond issuer; a Government issued Bond might cost $94, while one issued by BHP might cost $85). Now for ordinary investors they might be worried about things like interest rates affecting the value of the Bond, and so this must be taken into account when calculating the asset’s volatility. Again, the ALM investor has no such trouble. They don’t care about the asset’s volatility, in fact for her volatility is a good thing as it potentially offers an opportunity to jump out of the asset and take a profit before it matures. If the market price of the asset falls prior to maturity it doesn't really matter, as they know they will ultimately get their $100 on 1 January 2020. This gives it an asymmetric risk profile. For a better (albeit more complicated) discussion of risk, I recommend looking at measures that take asymmetric risk profiles and consumer preferences into account (eg. Omega Risk, Sortino Ratio).
(b) Over the long-term the overwhelming majority of the price increases in property can be attributed to inflation. In fact, even in Australia (which has the strongest performance of any country over the past 100 years), prices have only increased by about 0.9% p.a. above inflation. While rental income has lagged over the last 30 years, long term we should expect it to also track inflation, and possibly out-run inflation in the short to medium term. As such, for the purpose of allocating assets to future expenses, we can focus attention on your cash flow needs after taking into account rental income (i.e, if you need $70k p.a. and rental income is $35k p.a., then we only need to set capital aside to fund $35k p.a., plus a buffer for times of unexpected expenses and vacancy).
(c) The reason we don’t see many advisers or asset consultants using ALM frameworks is that they are notoriously difficult and expensive to manage. The fall from grace of traditional ALM is largely due to the large-scale bankruptcy of (mainly US) Defined Benefit Schemes. Think about the example of your boat purchase above. Now clearly if we made the assumption that returns were going to be 7% p.a. above inflation and not 3.5% p.a. above inflation we would need to allocate a lot less toward your future boat purchase (in fact only about $18k). Now, if we allocated $18k but returns were only 3.5% p.a. we would only have $30k after 15 years; so we would be $10k short. This is what happened to many large Defined Benefit funds. They thought that future returns would be higher than they were, which meant that the amount they set aside was much, much less than they actually needed. The result is that when it came time to pay the future expense they didn’t have enough money.
In this real-world example, it wasn’t a boat they needed to pay for, it was peoples’ retirement pensions. As they didn’t have enough money to pay everyone they owed they went bankrupt and people were left without the retirement income they were promised. Regulation in Australia provides much better protection for consumers, but as this example illustrates this is one of the reasons that Defined Benefit funds have fallen out of favour globally. That aside, it is a very good way of making asset allocation decisions; you just need to be very careful to get your return expectations right! (so there you have it; a lesson in the history of ALM!).
(d) A continuation of above, regarding costs of ALM. I mentioned that ALM is difficult and costly. This is generally the case, however if you are doing it just for yourselves it needn’t be. One of the reasons ALM is so tricky and expensive to manage is that normally it is used by large Pension funds, where they need to factor in a very wide range of "unknowns" (variables), including peoples' planned and unplanned retirements, different levels of contributions, number of employees, workplace liabilities (like work injuries), just to name a few.
When planning ALM for your own situation most of these variables don't apply. Instead our focus is on getting the investment risk budget (exposure to volatility and investment risk) right. As a result, a review and rebalance every 12 - 18 months is usually more than enough to keep things on track. Keep in mind that while we might determine that the optimal allocation is, say, 7% Australian equities, 13% North America (etc etc), this does not mean that a rebalance is necessary if you wake up one day and it’s moved to 5% Australian equities and 17% North America. Generally speaking you want to minimise the amount of trading that you do (excess trading erodes returns through increased taxes, brokerage and buy/sell spreads).
(e) For many people the idea of allocating money now, for expenses that aren’t due for 10 or 20 years into retirement feels very strange. An alternate way of thinking about it is to take the perspective of an investment Trustee (that is, you are responsible for managing the capital on behalf of someone else).
Example: Let’s say you have an agreement with someone, let’s call him Dave, whereby you will pay Dave a pre-agreed sum in the future. You are given a pile of cash today, but it is insufficient to pay all the future expenses that you must pay to Dave. If the money runs out that’s too bad; you still need to pay Dave, even if this means digging into your own pocket. This may mean you need to sell your assets/home etc. You work out that you need an average return of about 4% p.a. to meet all expenses. If you simply invest in a portfolio that you hope will return 4% p.a. then you may or may not have enough to meet all future expenses, and if the markets take a fall during the first few years you might be left very short.
If, however, you used an ALM framework you would be less sensitive to market risk during the early years and more sensitive in the later years, allowing you to have a greater exposure to risky assets in the early years (when we are a long way from actually needing to fund the expense), and less exposure as we get closer to D-day. The reason this works is that risk (volatility) is mean-reverting, meaning the proportionate benefit of compound returns increases over time, while proportionate risk reduces. This is because, mathematically speaking, against a normal distribution of returns volatility increases at the square-root of time. In other words, 1-year volatility of 5% will be expected to grow to about 10% over 4 years, 15% over 9 years, and 25% over 25 years. This, in turn, is equivalent to annualised volatility of 5%, 2.4%, 1.6% and 0.90%. This is one reason why it is often easier to make more accurate long-term return forecasts than short-term forecasts. One of the really interesting things about this approach (and the mathematics behind ALM) is that you end up with a portfolio that classifies risk differently to traditional portfolio theory.
A really good example is something like the way that Bonds are priced:
Bonds are issued by companies (or government) to raise capital. They do this by agreeing to make a repayment to you (the prospective lender) at a fixed price, at a fixed point in time (say, 10 years from now). Regardless of whether they pay "interest", Bonds are essentially priced the same way: the current value of the Bond is equivalent to the present value of all future payments to you, from today until maturity. For an ALM investor, if someone has a future liability of $100 due on 1 January 2020, they can buy a Bond with a face value of $100 and maturity date of 1 January 2020 (the price of the Bond will depend on few factors, but is usually linked to the yield curve and risk associated with the Bond issuer; a Government issued Bond might cost $94, while one issued by BHP might cost $85). Now for ordinary investors they might be worried about things like interest rates affecting the value of the Bond, and so this must be taken into account when calculating the asset’s volatility. Again, the ALM investor has no such trouble. They don’t care about the asset’s volatility, in fact for her volatility is a good thing as it potentially offers an opportunity to jump out of the asset and take a profit before it matures. If the market price of the asset falls prior to maturity it doesn't really matter, as they know they will ultimately get their $100 on 1 January 2020. This gives it an asymmetric risk profile. For a better (albeit more complicated) discussion of risk, I recommend looking at measures that take asymmetric risk profiles and consumer preferences into account (eg. Omega Risk, Sortino Ratio).
6. Be Opportunistic, but Patient
While we advise investors to look at the big picture over the long-term, markets will, by their very nature, swing to extremes. Markets go from being very overvalued to very cheap within a short time. This is a topic that requires considerable time to properly explain, but the key message is that it is perfectly normal for markets to be seemingly “mis-priced”. As a general rule, trading (switching investment options etc) should be kept to a minimum. However, we should also be opportunistic, particularly when markets provide opportunities to lock in profits which guarantee that future asset-targets are met.
The problem is that what may appear expensive or cheap to you or I is the price that the market (made up of numerous parties buying and selling at mutually agreed prices) have decided is a fair price for the future earnings of that particular asset, relative to all other alternative assets. Therefore “the market” is never “wrong”; it just holds a different opinion of value. If you think you “know” better than the rest of the market, then you need to have a basis for that view (do you know something the market doesn’t? Are you simply more tolerant of risk than the market? etc). If you cannot clearly articulate why you hold a different view, then you are going in blind.
This is why we encourage all investors to be patient. With the normal gyrations of the market, we can expect the price of the market to be below-average roughly half the time, and above average roughly half the time. Moreover (and this is where we focus our attention), approximately 10% of the time the market will be about 2 standard deviations above or below the average (mean). We focus on these ends of the spectrum for a very important reason:
The higher the price we pay for an asset, the lower the prospective return and the greater the chance that the price will fall. In other words, we get both a lower return and a larger amount of risk! In equity-market terms, a +/-2-standard deviation gap is roughly equivalent to a 67% change in price (from low-to-high, from high-to-low approx. -40%)
Of course it’s always easy to see risk after the event. Indeed some might argue that risk does not exist until after an event proving it’s existence occurs, and if we knew about it before it occurred it wouldn’t really be risk! Part of the challenge for investors is coming to terms with the fact that strong recent performance (as we might see when an asset becomes overvalued) will improve past performance, which in turn leads many investors to draw the conclusion that prospective returns will be higher (it does, of course, inflate the average, which causes major problems in traditional portfolio construction methods such as Markowitz Portfolio Optimiser / Efficient Frontier).
To see how this works in practice, think back to your ALM portfolio.
The problem is that what may appear expensive or cheap to you or I is the price that the market (made up of numerous parties buying and selling at mutually agreed prices) have decided is a fair price for the future earnings of that particular asset, relative to all other alternative assets. Therefore “the market” is never “wrong”; it just holds a different opinion of value. If you think you “know” better than the rest of the market, then you need to have a basis for that view (do you know something the market doesn’t? Are you simply more tolerant of risk than the market? etc). If you cannot clearly articulate why you hold a different view, then you are going in blind.
This is why we encourage all investors to be patient. With the normal gyrations of the market, we can expect the price of the market to be below-average roughly half the time, and above average roughly half the time. Moreover (and this is where we focus our attention), approximately 10% of the time the market will be about 2 standard deviations above or below the average (mean). We focus on these ends of the spectrum for a very important reason:
The higher the price we pay for an asset, the lower the prospective return and the greater the chance that the price will fall. In other words, we get both a lower return and a larger amount of risk! In equity-market terms, a +/-2-standard deviation gap is roughly equivalent to a 67% change in price (from low-to-high, from high-to-low approx. -40%)
Of course it’s always easy to see risk after the event. Indeed some might argue that risk does not exist until after an event proving it’s existence occurs, and if we knew about it before it occurred it wouldn’t really be risk! Part of the challenge for investors is coming to terms with the fact that strong recent performance (as we might see when an asset becomes overvalued) will improve past performance, which in turn leads many investors to draw the conclusion that prospective returns will be higher (it does, of course, inflate the average, which causes major problems in traditional portfolio construction methods such as Markowitz Portfolio Optimiser / Efficient Frontier).
To see how this works in practice, think back to your ALM portfolio.
Example 1. Portfolio perfoms stronger than expected
Let’s say that we set aside $27k to buy your $40k boat in 15 years time. Fast forward 5 years and the market has had a very good run, with the value of this savings pool growing to $37,000. You still have 10 years until you need the cash for your boat, so what do you do?
If we think of this problem in ALM terms, we might see that to fund $40k in 10 years we should set aside $34.1k, meaning we have about $3k (8.5%) more than we need. We can then separate this from the initial investment and treat it as an investment “reserve”, which can be used to top-up funds when returns fall short.
Being a reserve, and not allocated to your pre-planned cash flows, this account should have a near indefinite investment horizon. This doesn’t necessarily mean you should invest it all in risky assets, but as risk (volatility) is not linear over time (remember, square root of time) time we can afford to take more risk than might otherwise be palatable. In this example your $3k fully invested in risky assets (at 5.2% p.a., volatility 10%) would be expected to grow to about $5,000 after 10 years, with a roughly 95% probability of it being worth somewhere between $3,400 and $6,600.
Example 2. Portfolio perfoms weaker than expected
After 5 years and the market has performed poorly, with the value of this savings pool falling to $20,000. This scenario would be akin to the market falling by 35%. However, with this fall and holding earnings steady, the prospective return on risky assets would increase to about 8%. Under an ALM model this would require an investment of about $23,000 in order to meet the $40k target in 10 years.
This leaves us about $3k short for this particular cash flow, however it has an interesting effect on the overall portfolio. It reduces the amount we need to set aside for all cash flows, with the effect stronger the further away we are from the expense being due. For someone with a 40 years of planned expenses (such as might be the case for your retirement) the total assets needed to fund liabilities reduces by about 33%.
This doesn’t make up for the fact that our portfolio has lost value, but it does make it more manageable and should provide you with some clues as to why using this approach for entire portfolios and long investment horizons can prove valuable in both growing and protecting the value of your capital.
Let’s say that we set aside $27k to buy your $40k boat in 15 years time. Fast forward 5 years and the market has had a very good run, with the value of this savings pool growing to $37,000. You still have 10 years until you need the cash for your boat, so what do you do?
If we think of this problem in ALM terms, we might see that to fund $40k in 10 years we should set aside $34.1k, meaning we have about $3k (8.5%) more than we need. We can then separate this from the initial investment and treat it as an investment “reserve”, which can be used to top-up funds when returns fall short.
Being a reserve, and not allocated to your pre-planned cash flows, this account should have a near indefinite investment horizon. This doesn’t necessarily mean you should invest it all in risky assets, but as risk (volatility) is not linear over time (remember, square root of time) time we can afford to take more risk than might otherwise be palatable. In this example your $3k fully invested in risky assets (at 5.2% p.a., volatility 10%) would be expected to grow to about $5,000 after 10 years, with a roughly 95% probability of it being worth somewhere between $3,400 and $6,600.
Example 2. Portfolio perfoms weaker than expected
After 5 years and the market has performed poorly, with the value of this savings pool falling to $20,000. This scenario would be akin to the market falling by 35%. However, with this fall and holding earnings steady, the prospective return on risky assets would increase to about 8%. Under an ALM model this would require an investment of about $23,000 in order to meet the $40k target in 10 years.
This leaves us about $3k short for this particular cash flow, however it has an interesting effect on the overall portfolio. It reduces the amount we need to set aside for all cash flows, with the effect stronger the further away we are from the expense being due. For someone with a 40 years of planned expenses (such as might be the case for your retirement) the total assets needed to fund liabilities reduces by about 33%.
This doesn’t make up for the fact that our portfolio has lost value, but it does make it more manageable and should provide you with some clues as to why using this approach for entire portfolios and long investment horizons can prove valuable in both growing and protecting the value of your capital.
7. Time is on your side
From your current position you have potentially 40 years of investing ahead of you. You need only glance back over history to see that over that period of time we have seen no fewer than six recessions, four major market corrections and more than a dozen commodity-related booms and busts. What this tells us is that, from an investment perspective, you have time. While you still need to control risk, you should be prepared to take on assets that other investors might not be so comfortable holding. Nearly every market will provide investors with compensation for volatility and illiquidity. So long as you are being paid appropriately for these factors, you have a way to enhance returns without necessarily taking on any additional investment risk.
When thinking about investment horizon, also think about your children. They might be 40 or 50 years from their own retirement, which puts their own investment horizon somewhere around the 70-year mark. Based on the average real return from developed market equities (over the past 100 years), a 40 year investment of $1 would have turned into about $3.68. Over 70 years $1 would have grown to more than $6.20. Cash, on the other hand, will have lost value.
A final comment on this. Some advisors will use this as justification for investors always being invested in the markets (be they equity, debt or alternative assets). That is the wrong way to think about it. There will be times where it makes sense to purposely reduce market exposure and risk.
The line of reasoning used by those proclaiming investors should be "always invested" is that over the past 100 years the best five performing years have contributed about 447% to total returns; or about 1.71% p.a. (about 65% of all returns). What they fail to tell you is that the five worst-performing years would have wiped 90.7% from the value of your portfolio. Ok, to be fair most of those advocating to be "always invested" are usually doing so in good faith, it's just that they are basing their claims on research conducted by investment firms who are in the business of investing clients' capital. My view on capital allocation is to follow the cash flow, be compensated for risk, and try to avoid being caught up in mass (irrational) euphoria. This may mean holding unattractive assets - like cash - at times where the market tells us we're stupid for doing so.
When thinking about investment horizon, also think about your children. They might be 40 or 50 years from their own retirement, which puts their own investment horizon somewhere around the 70-year mark. Based on the average real return from developed market equities (over the past 100 years), a 40 year investment of $1 would have turned into about $3.68. Over 70 years $1 would have grown to more than $6.20. Cash, on the other hand, will have lost value.
A final comment on this. Some advisors will use this as justification for investors always being invested in the markets (be they equity, debt or alternative assets). That is the wrong way to think about it. There will be times where it makes sense to purposely reduce market exposure and risk.
The line of reasoning used by those proclaiming investors should be "always invested" is that over the past 100 years the best five performing years have contributed about 447% to total returns; or about 1.71% p.a. (about 65% of all returns). What they fail to tell you is that the five worst-performing years would have wiped 90.7% from the value of your portfolio. Ok, to be fair most of those advocating to be "always invested" are usually doing so in good faith, it's just that they are basing their claims on research conducted by investment firms who are in the business of investing clients' capital. My view on capital allocation is to follow the cash flow, be compensated for risk, and try to avoid being caught up in mass (irrational) euphoria. This may mean holding unattractive assets - like cash - at times where the market tells us we're stupid for doing so.
More Information
We are in the process of preparing a strategy paper for you which will help link the discussion above to your own situation.
In the meantime if you have any questions please contact me directly:
Joel Mitchell
0406 695 257
In the meantime if you have any questions please contact me directly:
Joel Mitchell
0406 695 257
About your Adviser
Your wealth adviser is Joel Mitchell, CFA®. As Senior Portfolio Manager and Director of Insight Wealth Solutions, Joel has been providing strategy and investment advice to clients for over a decade and presently advises on a portfolio of assets valued at more than $220 million on behalf of superannuants, professional investors, charitable foundations and the Australian government.
Joel is a Chartered Financial Analyst (CFA), Fellow of FINSIA, holds a Masters degree in Applied Finance, Certificate in Investment Performance Measurement (CIPM®), Graduate Diploma of Financial Planning, and has expertise in Self-Managed Superannuation Funds, mortgage broking, stock broking, taxation law, business succession planning, property economics, resource operations and engineering. Before beginning his finance career he was a paratrooper and assault pioneer with the 3rd Battalion, Royal Australian Regiment.
Outside of work, Joel is on the Education Advisory Committee (EAC) for CFA Institute and is regularly called on to sit on the Board of Management and advisory committees of not-for-profit organisations and private companies. He is also the author of “Not for Profits in Australia: A Boardroom Guide to Asset Management” and “IWS Residential Property Review”.
Joel is a Chartered Financial Analyst (CFA), Fellow of FINSIA, holds a Masters degree in Applied Finance, Certificate in Investment Performance Measurement (CIPM®), Graduate Diploma of Financial Planning, and has expertise in Self-Managed Superannuation Funds, mortgage broking, stock broking, taxation law, business succession planning, property economics, resource operations and engineering. Before beginning his finance career he was a paratrooper and assault pioneer with the 3rd Battalion, Royal Australian Regiment.
Outside of work, Joel is on the Education Advisory Committee (EAC) for CFA Institute and is regularly called on to sit on the Board of Management and advisory committees of not-for-profit organisations and private companies. He is also the author of “Not for Profits in Australia: A Boardroom Guide to Asset Management” and “IWS Residential Property Review”.