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Picking winners: the origins of the specious

“Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.” Paul Samuelson, Nobel Prize for Economic Sciences, 1970

If we believe the financial press, superannuation has been wrongly turned on its head. Every week in our highest profile financial newspapers and magazines, we have headings like: “Exclusive fund superstars - investment tips from top managers.”  It’s as if long-term investors need to respond to daily announcements and behave like traders.

Samuelson reminds us that when saving for retirement, investors should expect some level of boredom in their investment returns. Warren Buffett has said that he buys investments "on the assumption that they could close the market the next day and not reopen it for five years."

The superannuation goal is to have an adequate balance after your working life to live according to your expectations, but not worry about the markets every day.

How best to achieve this goal has led to debates around fundamental principles such as: the robustness of current asset allocation techniques; use of optimisation models; appropriate risk levels; the definition of risk; passive versus active management - to name a few. The fact such debates continue with rigour also shows that a lot of the ‘principles’ we take for granted should be challenged. Different perspectives should be encouraged and examined.

Focus on avoiding losers, not picking winners

One traditional focus is on picking winners as opposed to avoiding losers. The former makes for great news articles (when someone does get it right) whilst the latter is more akin to Samuelson’s quote.

Have you ever noticed the language of English Premier League football managers when interviewed post match? Those challenging for the title will refer to ‘points lost’ or ‘given away’ as critical, acknowledging that, as soon as too many points are lost throughout the season, the title chase is effectively over. For those at the bottom of the table, there is also the expression of the need to achieve, say, 41 points to stay in the League, i.e. an aspirational target.

This illustrates something that most of us know instinctively when investing and is routinely mentioned as a behavioural preference. If asked: “would you give up some upside to protect downside?”, most answer “yes”. Numerous behavioural finance studies show that we dislike incurring losses far more (by around a factor of 2) than we ‘enjoy’ making profits. Yet it is questionable if this philosophy is accurately reflected in current asset allocation and risk management practices.

The one thing we can say definitively on our superannuation journey is that during the intervening years from commencement until retirement, there will be ‘up’ years and ‘down’ years for anyone investing in other than cash.

Superannuation needs to preserve capital

It is our belief that the primary focus of the wealth management industry has changed from conservation of capital, with the ability to take advantage of compounding and long term horizons as core principles, to that of picking winners in the guise of various ‘risk adjusted’ frameworks.

But there should be more focus on minimising the ‘points’ lost rather than maximising the gains required. The reason is clear. Upon incurring a market loss a larger return is required simply to get back to where you started. As a simple example, consider the following two investors, both investing $10,000 at the end of May 2000.

  • Investor 1 invests $10,000 in the ASX 200. Here the volatility is approximately 12% per annum.
  • Investor 2 is more conservative and invests $10,000, 40% in the ASX 200 and 60% in cash. Here the volatility is approximately 5% per annum.

What were their experiences like?

Both investors had a good time up until September 2007. At this point, they were fine, with about $30,000 and $20,000 in capital for Investors 1 and 2 respectively. Then disaster struck. Investor 1 was hit with a drawdown period that lasted from September 2007 until January 2009, culminating in a total loss of 49%. Meanwhile, Investor 2 did not escape unscathed. A total loss of 17% was accumulated from September 2007 until January 2009. In order to return to the equivalent capital balance prior to September 2007, the total required return for Investor 1 was 92% while Investor 2 was 22%.

We assume for this illustration that both investors kept the faith and did not change their asset allocation.

How long did it take these investors to return to break-even? For Investor 1, it took six years to recover. For Investor 2, it took two and a half years. As an aside, by the end of January 2014, the annual realised return since May 2000 for Investors 1 and 2 was 5.5% and 4.7%, respectively. The realised annual volatility over the (nearly) 14-year investment was 13% and 5%, respectively.

This example illustrates something we all know. As the loss increases, the return required to retrieve your capital increases exponentially.

More importantly, neither of these relationships is linear and neither bears any relationship to the ‘risk’ that, as measured by volatility, these investors suspected they were taking.

Furthermore, the assumption that both investors stayed with their initial allocation is an optimistic one. There is a high likelihood they would have changed their allocations, especially away from equities after such a scare, causing the recovery time to be even longer.

Whilst ‘value add’ in the form of picking winners is admirable and part of every participant’s core belief, it appears that, in the pursuit of validating this quest for long term, consistent alpha - even if it is risk-adjusted - the other principles of downside risk mitigation and the preserving of capital become diluted, or lost.

We suggest that a focus on minimising disasters and downside, whilst clearly not as exciting as picking winners, is a better goal and results in an improved, long-term outcome for the individual, as well as a less hair-raising experience for all.

 

Dr Leah Kelly and Paul Umbrazunas are Principals of AccumNovo Financial Group.

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