Investment Commentary: The long and the short of it

BY DAVID VAN SCHAARDENBURG

Like most investment professionals my first discipline each working day is to scan the news on financial issues then check key market and security movements.

Daily my colleagues and clients will ask me, “What happened in markets today (or overnight)?”

It pays to have a good answer, but I do wonder, “What’s the point?” and “Does it really matter?”.

Why? Because the investment industry’s focus on short-term trends and news is in contrast to the investment horizons of the vast bulk of our clients. For example, if you are turning 65 today, you’ll have on average between 22 and 25 years of investing life left. So what happens day to day is unlikely to have a material impact on your investment success over that horizon.

With KiwiSaver, the increasing proportion of the advice industry’s clients are below 65 so with investment horizons for most getting longer why not screen out “the white noise” and consider longerterm issues.

In this time of lower forecast returns from mainstream investment types, especially low volatility assets, I do wonder if some of the aspects of a conventional advice and fund selection process can leave clients worse not better off.

A prime example of this is the use of return volatility as the key definition of investment risk.

Volatility of returns in both client risk profiling and risk assessment of a financial product is usually expressed in annualised timeframes over the last five years. Fine in theory, but where investments in liquid assets or asset classes which are priced daily inevitably will end up being deemed and labelled more “risky” – including by the processes prescribed by the industry regulator. So instruments like shares that are traded daily are deemed “more risky” than a subordinated loan which typically has stability in its value until a credit event occurs, often leading to a sharp decline in value.

When using volatility measures in a risk profiling process, the greater risk may be that we reduce the potential for clients to achieve their financial goals not improve them as potentially risky assets could be deemed “low risk” by virtue of time gaps in valuation and vice versa. When we add in potentially distortionary labels to client risk profiles or investment funds we may further exacerbate this problem. For example most of my clients prefer being termed “conservative” or “balanced” not “high risk” or “aggressive” without fully understanding the potentially negative investment implications of this.

A suboptimal outcome from the above has been the preponderance of KiwiSaver members investing in lower return default, conservative and balanced funds notwithstanding that their investment horizons are over many decades.

By using short-term return volatility measures in the client risk profiling process and investment product risk categorisation processes, many investors are shying away from higher return asset classes and a range of potentially high quality investments. For example a portfolio of successfully growing companies in dynamic industries (IT, healthcare) will appear more risky than investments that have other types of risk, which I maintain may not be effectively incorporated into the product risk assessment process. These risks include: structural risk, credit risk, liquidity risk, low return risk.

Using only one measure of risk to define risk can be risky itself!

There has been plenty of behavioural finance studies which support the view that investors do not like their investments fluctuating in value (downwards in the main) and require an extra payback in terms of higher returns to compensate for this perceived higher “risk”.

Such studies conclude that the more your investment goes up and down in value over the short term the more risky (worse?) it must be. So if you can cope with that then you are “aggressive” or if not, you are “conservative”.

However what might be more useful is for investment advisers to spend more time educating our clients to accept the cyclicality of economies and markets (risk and volatility is therefore ok) and be more focused on what they can do and be aware of to help better achieve their financial goals.

My number one concern is the probability that a client will not achieve their retirement financial goals which either start several decades away or are spread over multi-decade periods.

While some clients have sufficient wealth that the probability of goal achievement is very high no matter what the level of risk they take, most clients will increase the probability of goal achievement by sacrificing shorter-term return stability for higher average longterm returns.

This conflicts with the traditional client risk profiling and fund risk categorisation processes.

By being based on relatively shortterm risk measures, these processes encourage clients towards investing in less volatile lower returning investments. And by investing in such, reducing the probability of clients achieving their longer-term financial goals.

As of today, long-term future returns from low risk assets like bonds and cash are forecast to be at record low levels. Not much above nil and probably below the rate of inflation. In the US the traditional 60/40 growth asset to income asset retirement portfolio formula is now regarded as redundant. A 100/0 growth to income portfolio for retirement investing is now increasingly favoured.

In the same fashion, most New Zealanders building up their retirement wealth will need to accept a climb up the risk (volatility) ladder above what has been historically required. It is important this step up is done in an educated fashion ie not taking on risks they are not aware of.

Many investors probably need to take on more investment risk than they presently do. There’s a proliferation of financial products being developed to satisfy this need, each having risks which are often difficult to assess.

As we’ve experienced in the past this combination can be a formula for disaster.

There’s the increased promotion of unlisted property products which promote high versus bank returns. Additionally we see the launch of a number of high “income” funds.

On the surface the returns offered look appealing. Short term these investments have the appearance of stability and relatively low risk. Longer term they carry a mix of liquidity, credit and lack of diversity risks.

In this environment the role of the adviser is highly important in two ways.

First, managing expectations of clients investing in areas they may be unfamiliar with. Second explaining the unique risks a financial product may have and the potential implications if these are realised.

Through their adviser, being “forearmed is forewarned” will help steer investors away from taking on higher risk in a naive fashion as well as clients better appreciating the periodic bumps in the value of their investment portfolio. A

Note

Fund risk indicators must be based on annualised standard deviations, calculated using the change in week-to-week returns or (if not available) month-to-month returns over five years.