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Why top of the table returns don't always deliver best results

Michael Armitage  |  27 Dec 2018Text size  Decrease  Increase  |  
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Albert Einstein once called compound interest the eighth wonder of the world: those who understand it, earn it; those who don't, pay it.

The financial services industry understands it, but the way it presents investment returns often ignores it.

The result is investors lose out. 

Investment performance tables often present returns by adding total annual returns and dividing by the number of years to produce an average annual return.

It fails to show the impact of volatility and capital losses and how they erode the power of compound interest (which occurs when earning interest on top of interest) leading to lower long-term investment returns.

Consider the performance of two hypothetical portfolios over five years in Figure 1 below. Each portfolio produces an average return of 4 per cent a year.

However, the compound annual growth rate (CAGR) of Portfolio B and the final account balance are both higher despite Portfolio B underperforming in four of the five positive years in the table below.

Sacrificing some upside participation in order to manage negative environments delivers the better outcome in the long run.

Figure 1: Average investment returns ignore compound interest

Milliman figure 1

Source: Milliman

The reason is Portfolio B's lower volatility and lower maximum drawdowns through time, allows the power of compound interest to work its magic on the final result.

As markets turn into negative territory, a portfolio that retains most of its account balance is best poised to benefit from the market rebound. By avoiding the worst of the market downturn and volatility, investors have less need to capture the maximum return when markets are strong.

It underscores the irrelevance of looking at one-year investment returns or average returns that don't take into account compounding.

Managing volatility and drawdown are the keys to meeting long-term goals

Long-term investment returns should reflect risk but, in the real world, timing is everything.

Over the six-month period between September 2008 to February 2009, the median  superannuation balanced option fell 18.5 per cent, while the median growth option experienced a drawdown of 23.2 per cent, according to SuperRatings.

By way of contrast, average net annual return delivered by most large super funds over the 20 years to 2016 was 5.7 per cent – a figure which hides the impact of major drawdowns and volatility.

However, managing these factors is crucial to maximising real-world goals.

For investors in or near retirement and beginning to replace their salary with their life savings and investment returns, these market events create significant changes to their quality of life. Without the ability to add to their savings when markets fall and simultaneously reducing their account balance to fund living expenses – the power of compounding has been severely diminished.

Diversification through owning a broad range of assets across stocks, bonds, and alternative investments – provides some protection. But the behaviour of many assets become correlated during severe stressed periods, such as the GFC; providing fewer benefits than many investors expect.

In some cases diversification also lowers compound returns by lowering exposure to growth assets, such as equities. Further, investing in strategies with higher management costs and added complexity to diversify may not improve long-term outcomes. At a minimum, added complexity may only serve to increase unpredictable outcomes.

Finally, traditional defensive investments represented by historically low global risk-free real rates of return continue to challenge investment managers and investors alike. While equity valuations have seemed high in recent times, many an active manager has looked foolish by de-allocating from risky assets over the past 2-3 years.

All is not lost. There are ways to provide more predictable explicit portfolio protection to growth assets aimed at capturing more upside performance while reducing exposure in negative market periods, thereby creating more compounding potential for investors seeking to build capital over the long run and help retirees manage the need for income and growth, increasing their likelihood of meeting sustainable goals throughout retirement.

Investment performance tables shouldn’t be the only performance metric for investors who want to generate the strongest retirement incomes because they rarely reflect real-world experience.

Rather, a focus on managing volatility and drawdowns will lead to better retirement outcomes.

 

 

is head of advisory services at Milliman

This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. 

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