Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 54

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.

 

RELATED ARTICLES

Survive the next crash by learning from the Stoics

Stocks are less risky than bonds in the long term

Bill & Ted’s (Not So) Excellent Sequencing Adventure

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.