Give me the long-term predictability of shares, at any age

Its a nice chart but factoring in Inflation, $100,000 in 1979 was equivalent to around $345,000 in todays dollars. with retiring now at 65, that means 40 years ago a 25yr old would have to have had a spare (equivalent) $345k laying around...

I totally understand what the graphs showing but kinda unrealistic numbers....
What would the average 25yr old have in savings today? Can we do a chart (factoring in inflation) with that figure??

The average 25 year old would also spend the next 30 years adding a portion of their earned income to their portfolio for the duration of their career, as well as reinvesting their dividends. So, while their initial starting point is lower their accumulation would have three streams of dividends, career, earnings, and growth adding to the capital and subsequently the returns.

The chart was used as a visual aid to illustrate and compare the two investment strategies, not as a life plan for a 25 year old.

The Reserve Bank under Glenn Stevens fuelled the property market mainly for investors by taking rates down so low which has led to some retirees incomes being smashed. As housing prices went through the roof, it made it impossible for first home buyers to enter the market and even now we still have economists and advisers calling for more rate cuts from the RBA while the banks are and should be raising rates. The RBA made many people’s lives difficult. This is a bit off the track but just had to say this.

Hi Peter,
I have a significant amount of funds to invest for income/growth to the amount of $1m. What should i do in this moment, should I dollar cost average in or throw it all in one hit, or wait for a market crash?

Hi Anthony, we will publish an article soon with Peter's updated views.

Re https://cuffelinks.com.au/predictability-shares-age/


I would appreciate a copy of Peter's Chart updated version if that is possible. Great article.

email supplied below.

Hi Brian, we will publish an update from Peter in the new year. Cheers

All I can say is thank goodness someone has finally nailed this issue. If you have sufficient capital (say a few million $, and I know this is a small minority of people)) and which can be invested mainly in shares (say 80 to 90%, local and O/S)) which produces an income (say twice your normal annual expenditure) why would anyone want to adopt a life cycle investing strategy. However if you had say just $500k or less it would be very dangerous to go so heavily in shares because there will be a year or years where you will need to draw heavily on capital. Simple isn't it. The big disaster comes if the wealthy person adopts the life cycle model or the modest asset person adopts the 90% share model.

In case Peter doesn’t see your late post.

Prior to being listed as BKI the portfolio was initially created within BKW back in the 1980’s. BKI has minimal resource and listed property holdings make in predominantly an Industrial share focused portfolio. Albeit recently converting to external management the management agreement has set the Mgr fee at 0.10%. Other operating costs result in a total fee of around 0.17% which is very cheap for a fund their size given the much larger LICs charge similar. BKI could be considered part of the Millner family stable of funds which consists of the likes of SOL, BKW and MLT (a very old LIC). Putting this all together albeit not exactly meeting Peter’s previously mentioned rules it comes close enough:

1. Industrial focused portfolio
2. Been around a long time
3. Very low fee
4. Although now externally managed it’s management agreement especially in relation to rock bottom fee makes it somewhat unique and not all that different to being internally managed.

I have just seen this thread and there are some great comments and thanks for the article Mr Thornhill.

In regards to your LIC holdings. Do BKI meet the above criteria you mentioned? As they have external management and have not been around for 50 years. Just wanted to clarify this. And I understand you hold BKI in your portfolio. Is this correct?

Thanks

John

How would you mitigate a poor decade of economic growth straight after retiring? Similar to USA from 2000 to 2010. Dividends would drop straight after retirement and the cash buffer would all be eaten up by topping up the withdrawals, especially if dividends don’t return to pre retirement levels for 10 or more years. Michael Kitces and Wade Pfau have done some research (sp 500) on a U shaped equity allocation just before and after retirement. This may help alleviate the pain?

Not sure where you are sourcing your data from? I have the S&P 500 broken into income and capital; similar to the chart in my original article. Dividends continued growing from 2000 until the GFC, dropped back and then started to climb again. I also have the annual returns on the All Ords from 1900. There has never been a period of more than 2 years of consecutive negatives. If that's the experience over 117 years I cannot understand the need for 5 years or more of cash to carry one through. I'm so over academics. Unless of course, they are expecting the next meteor strike on planet earth.

Hi Peter,
Any comments about your retirement income strategy in the event that Labor wins the next election and changes dividend imputation as they have flagged?
Possible ways to minimise the damage?

Business as usual James. How did we cope with tax rates at 49% and interest rates of 16%. I lived in the UK during the 70's under a labour government (Harold Wilson and Chancellor Denis Healy) with a top tax rate of 98%. Healy's Paul Keating moment was; "we will squeeze the rich until the pips squeak". Life went on. By the way, there was also an investment income surcharge of 15% on top! The tragedy was the colossal waste of intellectual horsepower trying to avoid tax. Best way to minimise the damage if it is seriously a concern is to emigrate to a low tax region. In the 70's all the UK rock bands moved to France.

The loss of franking credit refunds will also result in those of us with SMSFs following Peter’s strategy having to sell shares much sooner in life to meet minimum pension withdrawal requirement.

The annoying thing is that many Public Offer Funds won’t be impacted by this proposed change. Pensioners in these funds will still likely receive their franking credit refunds. SMSFs may become less popular. Perhaps that’s Labor’s intent?

I think LICs will cop a capital hit (perhaps permanent) if the change gets implemented especially the more active LICs that generate income mostly through trading (capital gains). Other structures such as LITs, unlisted Funds and ETFs can pass the capital gains intact to the investor. And of course capital gains is tax free in pension mode. LICs unfortunately would pay company tax on profits but the imputation credits would be lost to the pension member.

The positive is that LICs will likely be discounted below NTA to compensate for any perceived disadvantage. Expect an initial knee jerk reaction which could result in outstanding opportunities. Not good for capital value but great for income investors able to continue to accumulate them. A return to the good old days where my favourite older style LICs were often trading at a discount to NTA rarher than a premium as is the case in more recent years.

Hi Rob and Justin, yes, there's no tax on the capital gains in pension mode, plus 15% tax in super with a 50% CGT reduction, so likely to be less than the 17.5% tax on taxable component paid to non-dependants. This 'death duty' should receive more attention, and it is covered in Mark Ellem's article this week.

Surely Graham, in trying to avoid the 17.5% tax you mention on paying superannuation out to a non dependent on the death of the retiree, you are going to lose more in capital gains tax? For shares held for a long time, even with the 50% CGT discount (increasingly unlikely to stand the test of time too, especially if a Labor govt is elected) the capital gain could be enormous!

Not if you're in pension phase when you sell, then commute the pension and withdraw a lump sum after that.

Ah, now I see. Thanks Rob!

Justin, the superannuation CGT discount is 33%, meaning that the fund will pay 10% instead of the usual 15%

Is this strategy undermined by Labor's just-announced changes to the treatment of franking credits should they be elected?

Peter I have been a great fan of you and your financial philosophy. I do have one issue that I fail to understand and hopefully you may be able to help me.
With my SMSF in which I have only LICs, I am required to withdraw each year 6% of the total as at 30 June the previous year. With the LICs you have referred to it is impossible to earn 6% so there would be a need to reduce the capital.
How do you do it?

You have raised what will be an issue for all retirees John. My simple-minded solution is as follows and I am assuming that you, like me, can live on the income that was received prior to be pushed up to 6%.
As we age, the mandated withdrawals will increase. We have opted to live on the grossed up income provided by the franked dividends, roughly 5%. In reality, as old habits die hard, we don't spend it all anyway.
It must be accepted that the longevity risk is getting higher (my MIL died at 96 and my mother just died at 97), and the likelihood of my wife outliving me requires serious consideration.
However, as the amount we must withdraw will exceed the dividend flow by a larger and larger margin, we will be forced to sell shares. As the income we receive will be greater than our requirements (by choice) I will use the excess income to repurchase the shares in our own names outside the super regime.

The end result will be a gradual transfer of the shareholdings out of super to be held personally. This will ensure that the growth in our income, whilst not as tax effective, will continue until final death.

There is also sense in this to avoid the 17.5% 'tax' paid on superannuation paid to a non-dependant. In fact, it would be a good move to have the paperwork ready to sign to transfer all money out of super as you lie on your deathbed. $175,000 per million is a decent incentive.

Hi Peter,

You've earned 15% p.a over the last 17 years?

I thought you invested in good old LIC's like AFIC?

Their returns over the past 10 years haven't been great 5.5% p.a, and only a smidge higher than the ASX 200 accumulation.

Also, on a seperate note, the Aussie market is heavily dependent on the big 4 banks and their yields. It's been a wonderful twenty years for the banks, however they are faced with three problems: our very high household debt levels (which they've profited from), disruption, and a Royal Commission!

Not just LIC's Ben. Whilst they are core holdings now I have held direct shares. Two employers going public whilst working in the UK. Ditto here. In the early years, following our return, I also bought direct shares.
Dumb luck also had a big role to play; Cochlear floated out of Pacific Dunlop in 1995 at $2.50! Similarly with CSL.
In fairness, I could also list the ones that went belly up; thankfully not many.
My financial advisor also has to take credit for keeping me out of trouble.
My concession to the 'lifecycle investing' is to wind down the direct holdings and shift more to the LIC's. I don't want or need a large number of shareholdings as we age.
The other thing that helped along the way was my refusal to touch resources and listed property. This alone would account for a fair part of the outperformance.

Excellent summary of the problem Andrew and sums up the dilemma of managing multiple clients, not just your own portfolio, or Peter's in this case, on which you can manage your own emotions or not. Much more difficult to manage other's emotions. Part of the answer is education, but in my experience as well, the education may not actually sink in, or it is abandoned when fear becomes real, hence we revert to the 'safe' approach. The no win no fee lawyers would have a field day with portfolios 80% in Australian equities, no matter the theory. That's why some choose to be educators and theorists I guess, and not personal advisers!

Spot on Phil,
I once considered very seriously becoming a financial advisor (I was already involved in the finance industry in another capacity) however I was unable to reconcile my own firm views on high ASX asset allocation and the importance of income above all else, to the "standard" approach of the "balanced" portfolio and the much lower outcomes that must occur as a result.
So I just stayed where I was and in the end was able to personally retire some 10 years ahead of most, if not all, of my colleagues and peers. This is not to "brag", I actually state this with a sense of disappointment for the missed opportunities of the majority caught up in the mire of the bog standard asset allocation world.

I am so glad I never became an advisor. Unconstrained by the 'religious dogma' of the industry I was able to step out and speak my mind. Just arrived home after presenting for an accounting firm in the Sydney CBD. The rare but treasured experience of having an elderly couple approach me; they had flown in from Armidale to thank me. They attended a presentation I did 20 years ago and wanted to thank me for totally changing their lives.
GOLD!!

Hi Peter,

Thanks for your article.

I have been an observer of yours over many years and agree wholeheartedly with what you say. As an adviser for 25 years, my career commenced in 1993, and shortly after that, I came face to face with the Bond Crash of 1994, when even "safe" investments fell in value (collapsed), and obviously every "crash" since that time.

When I was younger, I compiled possibly too many spreadsheets to prove theories such as yours for myself using actual client situations; nowadays I am happy just to know the truth.

My observations during over time is that volatility has never really mattered in client portfolios provided that they have had sufficient cash to meet their income and "emergency" needs.

In theory, I would like all clients to say hold near 100% in equities in their portfolio. However in the real world as advisers, we have to contend with the media setting expectations and trying to scare the daylights out of the public whenever the sharemarket undergoes repricing from time to time (what they call Australian's losing "billions").

Coupled with this, is the concept of "Risk Aversion" where some people simply do not have the appetite for any volatility, such is their fear that they will lose their hard earned.

In such cases, and as advisers we are under an obligation to "know" thy client and invest their funds accordingly. I know that when I invest a client's money in a "conservative portfolio," I am setting up the client to earn less over time.

If on the other hand, I were to do the right thing by the client and invest in a way that we know the client will be better off (i.e. shares), then when next the market falls, my conservative client will in all likelihood complain. This could then cause them to sell their investments of their own volition and crystallise the "loss".

This scenario would likely end up with me meeting the lawyers.

In my experience volatility for our clients is a concept until it becomes real, and the portfolio report shows a "loss". That is when the real test is applied, and then when they listen to the media, they panic.

My question then is how in the face of knowing what is right, how then do we deal with the reality of fear, risk aversion, misinformation and prejudice in clients.

(sorry if this has been already asked, as I have not read through all 55 replies).

Andrew

Andrew, you have hit the nail on the head.
Fear is based on ignorance; knowledge is power.
I have always felt for advisors.
Know your client? What a joke. You know many of them only until things don't go their way and then it is your fault.
The GFC was a great opportunity for many 'clients' who signed off on their plans to activate a 'put' option.

This is why I left the industry. I've spent the next 17 years trying to provide sufficient knowledge to enable people to make better quality decisions.

In retirement, income defines your lifestyle, not the size of your capital (eg, expensive house). In a low interest environment, poor returns condemn many retirees to supplementing income by progressively liquidating capital. Selling assets progressively increases longevity risk. Selling assets to generate income also exposes retirees to volatile market prices. Retirees who increase their asset allocation to cash or fixed interest in order to lower the volatility of market risk must also accept lower overall returns, thereby increasing longevity risk.

Australian equities are a conservative and stable source of income, producing greater income than any other asset class over time. Provided that capital is not liquidated to supplement retirement income, the volatility of the market prices is not a significant risk. Dividend income from equities depends on growing company profits, not market prices.

Inside a SMSF in pension phase, the full return of imputation credits from the ATO is a cash bonus. My SMSF consistently returns more than 7% income which is more than I need and allows me to continue to accumulate shares. Any growth in share prices merely makes these new shares more expensive.

My wife and I have been funding our retirement for 10 years, through some turbulent equity market cycles, with over 90% exposure to equities all the time, without the need to liquidate capital. This strategy produces high income that also keeps pace with inflation, while keeping income-producing assets intact. We can see no reason why that should not continue, regardless of how long we live. We do not consider that we have a longevity risk. Instead we have an estate planning problem.

Spot on, Jack.
These are our own circumstances almost to a tee. We are very comfortable with 90% exposure to ASX stocks and LICs both inside and outside of SMSF, and have been since pre GFC.

Another great article thanks Peter. In my view lifecycle investing is all about mitigating the business and brand risk for the big super funds, and not at all about mitigating risk for investors. Interesting that the increasingly widespread use of lifecycle investing is a uniquely post GFC event?

I didn't choose that point Peter for any other reason than to show reality to incomes. If 80K was the lifestyle need then their income didn't recover to that for nearly 10 years. So yes they needed a buffer of around 20% of the pre GFC portfolio value. Dare I say invested in Bonds! Dare I say a bit of a Balanced portfolio. Also since we are talking about starting points, and they do matter - your chart also conveniently starts in 1980 - the market P/E was under 10 at that stage from memory so well under average i.e. a great starting point and bound to make numbers look not bad over the next 15-20 years. Also, because I look at alternatives and risks, in the late 80's investors were able to lock in lifetime annuities at 16% - fact. That is around 64K on your balance then of around 400K vs share divs around 20K. plenty of people would take that virtually risk free offer. Hindsight is terrific, but my point is to survey the landscape at the any point in time and make a decision after considering all alternatives, but I realise you are not suggesting a one size fits all approach.

Thanks Phil. I didn't choose 1980 either.
Prior to December 1979 none of sub indices existed.

To show the merit of holding shares, I’ve done a simple example of someone who retired either at the end of 2007 or 2008 and held shares until 2014, which captures the impact of the GFC. To keep the calculations simple I picked Westpac as a proxy for an SMSF portfolio invested wholly in blue-chip dividend-paying Australian shares.

If that investor retired at the end of 2007 when his portfolio held 25,000 WBC worth $698,000, the SMSF would have received dividends in 2008 of $50,750 (including franking credits). That would have fallen to $41,500 in 2009 but then would have climbed to $65,000 in calendar 2014.

But had that investor postponed his retirement to the end of 2008, his portfolio at retirement would have been worth only $467,000 (including the extra 2,540 shares his SMSF would have purchased at year end with the dividends, net of 15% tax, received over 2008. That’s a fall of almost exactly one-third. Sounds like a terrible loss.

A sequencing-risk-driven calamity for the investor? Far from it, since the SMSF would have received dividends in 2009 of over $45,000 increasing to over $71,000 in 2014. That’s 10% better than had he retired at the end of 2007 despite the one-third fall in value by the end of 2008!

And it could be even better than that. I’ve assumed that the investor drew down a pension equal to the full dividend stream, over $45,000 in 2009, received by his SMSF, which equated to nearly 10% of the opening balance, $467,000 at the end of 2008. Had he instead drawn down just the minimum 4% of the opening balance each year, as do many SMSF pensioners, there would have been surplus dividend income left in the SMSF each year, leading to the purchase of still more WBC and therefore still more dividends and pension payments.

The illustrative results of this example would apply to anyone who maintained a shares-oriented portfolio over the period and didn’t succumb to the advice of well-meaning advisers to change horses midstream and switch out of their shares at retirement, bad advice which would have resulted in temporary market-value fluctuations being crystallised into permanent losses.

Well done Geoff. A splendid effort.

I'm always interested in what charts don't say as much as what they do say. I can't help but think that this chart would be much more useful if a persons starting required income/inflation linked was added. In the period pre GFC where income rose to 80K, it needs to be determined whether the investor needs all that 80K to live or they are only living on 50K. The subsequent drop to 50K meant that they would be required to sell growth assets to fund the shortfall, i.e. the recovery of capital wouldn't look anything like the chart. The chart assumes they could adjust to the 50K. In the real world this is unlikely, but that is the case with all theories.

Your arithmetic is correct Phil. Conveniently choosing the GFC as the starting point certainly does make shares look dodgy!
If people, having chosen shares, are unable to adjust to a short term correction in income and insist on maintaining their spending then they stuffed up. As I have pointed out in previous comments, they should have had a buffer just as we did. It would be foolhardy in the extreme to 'assume' unbroken increases.

Now, let's assume they didn't touch risky shares but used safe term deposits? With interest rates declining by around 80% from their peak, how are your sensible people coping with their income slashed? Spending capital?

Call me old fashioned but the aphorisms that have guided our lives are; spend less than you earn and borrow less than you can afford.
In the real world necessity is the mother of invention.

Thank you, Peter Thornhill.
Regards.

Thank you, John Tatler.
Regards.

All true except that ASIC will crucify any advisor that recommends anything other than the prevailing practice of “asset allocation”, and “conservative cash and bonds” for retirees or even people approaching retirement. And this is more ridiculous at the bottom of the rate cycle. The entire “industry” is now premised on avoiding litigation rather than a practical understanding of how financial assets actually work.

Thank you John, too true. This is why I left the industry in 2000.
I am particularly concerned about locking in low rates on long term fixed income investments at present. A hell of a time to be locking in an income stream.
Thank you also to Graham for reminding me of the requirement of the authorities, you must ignore everything I've written as it could be, perhaps, maybe or possibly construed as advice. Phew.

I emphasise that while this is an excellent discussion, Cuffelinks is not licensed to give personal financial advice, and any replies from Peter must be considered general information without knowing the personal circumstances of anyone. Peter's strategy will have short-term volatility regularly and few investors know whether they can tough it out over 40 years as he describes, especially in a panic. Cuffelinks is not responsible for any actions taken. Cheers, Graham

Great article and great feedback! You mention showing your hand and you mentioned the old school lics such as Argo, Milton BKI and Whitefield from previous articles and posts.

I have a query in regards to a 20 something year investor with no home loan debt (equity) available for equity loan into lics and wanting to DCA into say BKI and Whitefield for the next 25 to 30 years.

I'm sure this investor wouldn't blow himself up if all he did was purchase this 2 lics every quarter for the next 30 years when funds were available and ticked the drp box and also bought the share purchase plans and rights issues and rode out the volatility of the ups and downs of the share price whilst focusing on the dividend income stream and utilising the equity loan against the ppor when the market well and truly nosedives?

If I recall you mentioned that your son's are basically riding this lic dividend train also without trying to time the market or share price forecasting?!!!!

Regards!

You're right Patrick. All 3 sons have been investing for a number of years now. The regular share purchase plans (SPP) and rights issues are a zero cost opportunity to increase their holdings on a regular basis. Like their Dad, they all gear; eldest using the house to secure a line of credit and the other two using margin loans. Rather than putting in frequent additions, they plough the dividends back into the loans and then take bigger bites less frequently using the SPP and rights issues as zero cost entry points.

Without taking up too much space, our eldest son recycled his dividends through their non tax deductible home loan as additional capital repayments, then redrew them from a parallel tax deductible line of credit. As the dividends grew it accelerated the home loan repayments allowing them to pay off their home in 10 years. I might add that the tailwind for them was the fact that they bought a 'modest' house.

Peter, I heard you espouse your approach many years ago, and I was impressed. I remember your preference was for Australian industrial companies, and you did not care for resource companies.

I am a private client stockbroker and advise many of my clients with SMSFs to focus on leading company shares with a track-record of paying regular dividends. Typically my clients have 60% + allocation of assets in ASX200 shares and they earn 4.5%-to 5.0% income PLUS franking credits. Like you I am open to investing in the longer-standing LICs.

My clients are pleased to receive an annual cheque from the ATO for franking credit rebates. You do not get that for investing in foreign shares, ETFs and the like.

Thanks Peter for the informative article.
At 52, I am fairly new to the equity investment world and have been reading and learning through a few mistakes in buying shares and selling in fear.

Last May, in frustration at my poor mindset, I decided to sell all my equity holdings from my personal and my SMSF accounts and decided to purchase units in an unlisted investment company. To date my fund balance has increased by over 40%. It is early days of course, but until I have somewhat more confidence in myself I feel it is best to leave the equity purchases and selling to a professional with a proven track record.

What do you think of unlisted investment companies and in particular what risks, if any, do you see compared to listed investment companies or ETF's.

Once again thank you for sharing your thoughts and ideas on the subject. Kind regards, Scott

Hi Scott.
Personally, I'm uncomfortable with anything that is unlisted as liquidity could be an issue.
The liquidity provided by the ASX is a great source of comfort.
Having said that, you may never have to test the liquidity of the unlisted vehicle.

Shares are all very well if you hold them at the right time. Someone buying shares just before the GFC crash and holding in effect the market index would still hold shares worth less now than they were at the top of the market in November 2007. Of course there have been dividends, but the capital loss remains. A MUCH wiser approach was to sell the shares at the end of 2007 (which I did), and to start investing again at the beginning of 2009 (which I also did). This way, I have done far better than someone holding on to shares at all times or buying them at the wrong time (as would have been the case in late 2007). I also think that corporate bonds are often very useful when shares are obviously at risk, and deposits can play a reasonable role as well, if yielding enough. There is no need to hold on to just ONE asset class, and shares are extremely volatile: best held at certain times, but not at all. I speak as someone who has done well with shares plus the other categories since 1983. I do NOT believe that shares should be the only asset class to be invested in at all times. Sharp falls, such as the 50% during the GFC, can severely curtail the capital of the holder. And it would be nonsense to say that one could not see the fall coming.

Thanks John - can you tell us where you purchased your crystal ball?

Also - please let us know when you are selling and (then) buying your shares in the future.

That would be fantastic. Thanks.

John, I'm staggered. How did you go in 1987, 1994, and 2002? Did you pick the exit and re-entry points then?

I have a small problem though with the market timing practice you are proposing. When I have paid the tax on a couple of million dollars in capital gains plus the frictional costs of trading. I don't have the same money to put back in!

Hello Peter,

RE: Quote,Looking forward to next GFC. What % of cash is reasonable to hold for the next market downturn?

Holding some cash diverts from compounding equities. What's the balance?

Regards

Hard to quantify Paul. As I indicated in an earlier response, we carry two years pension payments in our SMSF. Outside super, I use our apartment for a line of credit which gives me access to quite a substantial sum. The end result is we can hit the go button at any time.
Funnily enough; the non super line of credit was a response to the fact that, on retirement, we were now holding a few hundred thousand in cash which messed up my 100 % allocation to equities. My solution was to borrow outside super to invest which meant that, the debt outside cancelled the cash inside super so that net-net, we remained 100% exposed to equities. Does that solve your problem regarding compounding?

Excellent debate and thought provoking article. Probably best not to polarize it into 100% shares vs life cycle investing / right or wrong. Theoretically it's hard to argue with the arguments made here. But as we know, real world investors do not follow theory. If you can stick to "all shares", pin that chart up on your wall and hold the line through the crashes, then the theory should play out well for you. Unfortunately, as easy as it sounds, most people cannot seem to do this. So in a practical sense, investors probably need to figure out their own ability to follow a plan. I won't use the words "risk tolerance" as it's a valid point that volatility is not risk. However people need to have some self awareness of whether they are going to be the person who can ignore all the "market meltdown" headlines and hold the line. Or are you a tinkerer who likes to do a bit of market timing and stock-picking on the side. Anyway, best to come up with a plan that fits your own investing psyche and one that you can reliably stick to. This theory will not work well for you if your moment of self discovery (i.e. that you cannot stomach a 50% portfolio drawdown, even if it's only temporary) occurs in the middle of a market crash.

That said I agree with the general sentiment and if you can get onboard with the logic behind this it does make a lot of sense to allocate more highly to shares for the long-term. And maybe some of those old maxims such as "your age in bonds" should be rightly challenged.

Couldn't agree more Adrian. Economics 101 has failed us; behavioural finance rules. I go to some lengths to tell people that the only barrier to success in life is the trash we carry in our heads. Fear is based on ignorance; knowledge is power.

Thanks Peter for your timely reminder and as it happens I had just finished a re-read of your book and ordered a copy for one of our adult children as she takes more interest in these matters. And I too remain amazed at how sensible people continue to take the brakes off equities when facing a hopefully long and fruitful next age. I too have a healthy regard for aging LICs which, if I can continue to squeeze funds from the gap in what we need and the amount of equity income coming in, then we will continue to DRP our way to further growth and yet more income. And hopefully at least some will transition into the next generation to keep your yellow lines inclining upwards. With the odd and soon to be forgotten blips along the way of course.

I've been called an 'evangelist' for fixed interest, but have always argued that if you're talking about investment time horizons of 15 years or more there is very little argument for the asset class over equities and property. The only exception I make is that there's always a case for including high yield bonds in your portfolio because over medium and long term periods, they return very competitively with those other asset classes. I wrote about this back in July 2014 - http://cuffelinks.com.au/invest-junk/ . But I totally support the asset classes that are volatile short term, provided you diversify them and don't concentrate your shares in, say, a handful of companies. (That creates the tail risk that if something goes wrong it hurts you really badly.)

The role of fixed income is in providing a better way of managing to a capital outcome over short to medium time periods. And we all have some of those. For example, we want to go on an overseas trip in, say, 2 years' time and we have the funds available today - then invest in a short term bond fund or a 2 year TD so that the money is secure.

That said, a $100,000 term deposit in 1990 doesn't have to still be a $100,000 term deposit in 2018 if you reinvest at least some of the interest you earn. I wrote about this here: http://cuffelinks.com.au/bonds-role-managing-inflation-risks/

In this context I would point out that it's unhelpful to look at a 14% interest rate in 1990 and allege that it's sort of disgraceful that interest rates have fallen since then. Such a loss of real value reveals poor investor behaviour rather than a poor asset class misbehaving. Inflation in the late 1980's was around 8-9%, so that 14% interest rate was really only giving investors 5% or $50,000. That is all they should have been spending if they didn't want their investment to erode with inflation. What we have today is an after-tax real return that is lower than this, for sure, but if they'd maintained the real value of their deposits through reinvesting the inflation component of their yield they'd be earning not much less than that in today's dollars.

Sadly, too many people dependent upon their investment income in the late 1980's, early 1990's chose - because they weren't advised to think differently - to let the real value of their investment decline. They suffered money illusion. Part of the share market's seeming superiority is merely a reflection of the fact that companies do reinvest earnings to grow. Investors can choose to do that too.

There’s only one problem with this article. It assumes that we are in the same financial territory now that we have been in for the last 37 years. In fact, we are not. Who wants to put money into a share market that is as overvalued as the one that presently exists. The so-called bull run that we are experiencing (particularly in the U.S.) is built on the back of quantitative easing, the likes of which have never been seen before. Eventually, the chickens are going to have to come home to roost and, when they do, anyone who buys into the market at the present time, may well see their precious investments fall in value dramatically. So, until someone kindly explains how quantitative easing is going to end, and how its impact is going to be anything but a gigantic mess, I would prefer to keep a significant portion of my financial assets in cash and term deposits.

Alan, we are in the same space we have been for the last 370 years. If you haven't read it, I recommend "Extraordinary Popular Delusions and the Madness of Crowds". First published in 1841.
"Men, it has been well said, think in herds; it will be seen they go mad in herds, while they recover their senses slowly, one by one".

I agree with your comment regarding the foolhardy experiment by central banks. I think we can be assured it will end in tears when we have the mother of all bond market crashes. However, I look forward to whatever black swan event stampedes the herd yet again. I am on record as saying I look forward to the next GFC.

The basis for this seemingly contrary view is based on my experience of the few we have experienced during our lifetimes (1973/4, 1987, 1994, 2002 and 2008). Having the good fortune to marry a saver we have been financial soul mates ever since.Whether nature and or nurture we have been able to get by spending less than we earned and borrowing less than we could afford.

This has ensured that when the going got tough, we could get going. We have, as pointed out by one contributor above, 2 years mandated pension payments in our self managed super fund. This obviates the necessity for us to sell shares to meet our pension requirements.
During the GFC, the value of our super fund almost halved but the dividends kept flowing replenishing the cash account. This meant that we were able to buy CBA at $26.00, Wesfarmers at $13.00, ANZ at $14.00, CSL at $36.00 and so on.

Outside super we use the property we live in as security for a cheap line of credit for share purchases. Ditto the above for our non super holdings. This meant that the subsequent recovery in prices was a nice bonus but the most exciting outcome is the fact that dividends from both CBA and WES alone have since returned over 100% of what we paid for those parcels of shares!
There is always an alternative to consider.

Worthy considerations. Thank you, Peter. Your approach is largely what I have taken but with a greater consideration towards cash/term deposits. It’s ironic, is it not, that a so-called defensive position involves having a substantial portion of investments in cash, term deposits AND bonds (presumably including floating rate notes). Yet bonds themselves may suffer the mother of all corrections at some point in the future.

Oh, and Daniel Parry, thank you very much for the reference to that extremely interesting article by Mark Kritzman.

I saw Geoff Warren of ANU speak recently on the issue of the impact of timeframe on asset allocation and his work clearly favours higher allocation to equities for longer investment timeframes. The point he made about some of the mathematical approaches is that some of the utility curves, consistent with risk aversion, are very harsh on significant falls in asset value. But like Geoff I think they are TOO harsh - ridiculously harsh.

Take the two utility functions quoted in the Kritzman article: one where the utility of wealth $W is ln(W) and one where the utility is -1/W. Consider a person who has $2 million in assets and let's say that they invest in risky assets and lose $1 million. Bad, hey? But then let's assume they are affected by a series of further personal mishaps (illness, divorce, loss of job) and, down to their last dollar, they put the dollar in a pokie machine. And lose. Using the logarithmic utility, when they lost $1 million, their loss of utility was ln(2) or about 0.7. Their loss of utility when they lost their last dollar was infinitely worse. Literally infinitely worse, their utility moved from 0 to negative infinity.

Same with the -1/W function. When they lost $1 million of their $2 million savings, their utility fell by - wait for it - an amount of 0.0000005. But when they lost their last dollar in the pokie, utility fell from -1 to negative infinity. So both these utility functions are demonstrably unreasonably harsh on the downside. With reasonable utility functions it is hard to see how equities could not be a relatively more desirable asset over a longer term timeframe.

Thank you John.
I appreciate your depth of technical analysis.

I think this is a BIG, IMPORTANT discussion topic and while I may disagree with one or two minor wording things or minor methodology things in Peter's article, for me the big picture is that individuals, both in their own private investments and inside their superannuation funds, are taking less than the optimal (utility-maximising) investment "risk". I could never figure out how a 30% allocation to growth assets could be right even at age 65: you have in the vicinity of 20 years further lifespan at that point so why go for lower returning asset classes when you must still invest for a long term horizon. To meet living expenses, volatility is almost irrelevant; a relevant question is, what could happen to dividends. Dividend streams are much stabler than market values, and even fairly severe potential downturns (e.g. GFC) can be handled with a relatively modest cash bucket to draw down on in unfavourable markets, especially if there is a little flexibility in the retiree's spending needs (this is Gary M's point, differently worded).

I could never understand it and thought I must be missing something but on three occasions, asset/superannuation consultants have told me that they agree - the default asset allocations are wrong - too conservative. Why? Trustees focus too much on the downside; members think of their super accounts as being like bank accounts and focus too much on reductions in the reported value of their accounts; members don't realise that markets will recover over time after "crashes"; members invested heavily in growth assets may switch out at the wrong times; etc.

Having said that, Peter (the commenter not the author) has a point (you can get reasonable returns from some "defensive" assets if you take some credit risk). So does Justin: if you need a lump of cash at some specific point in time, a volatile portfolio is not ideal) though in his aged care example, if markets has just crashed when someone needs to go into aged care, the person could always pay a DAP (daily accommodation payment) rather than a RAD (refundable accommodation deposit).

But in general I'm with the author: volatility is not the real "risk" and those more educated members who understand investments and take more volatility "risk" will, almost always, be well rewarded.

Great article and what i have believed for many years. Only issue is choosing good companies to begin. Holding on is also difficult, which goes back to the study that showed that investors with the best returns over the long term had passed away.

Thanks Franco. Having worked in the funds management business for over 50 years I have become very aware of the desire to stand out. What's your mantra as a manager; thematic, bottom up, deep value, contrarian, blah, blah.
However, I have adopted my own label; benign neglect!

Question for Peter Thorhill. Would you still recommend this strategy for a soon to be retiree with a smaller portfolio balance? ie 200000-300000k. How would you respond to Gary M’s 1 point if you had a smaller balance and had to retire? Also, how would you account for largish one off expenses?

Hi Jeff. Irrespective of the amount involved I would recommend it. Unless you have a use by date on your birth certificate be prepared for a long retirement.
Let me bounce your second question back at you.
You hold an investment property, cash, government and corporate bonds; how do you account for largish one off expenses: Which goes first?
Why is that holding shares is always the problem?
I love shares because of their extraordinary liquidity, the very thing that gives everyone else the vapours.
If I'm confronted with a medical emergency that requires a member of my family to be in Switzerland next week to hopefully save their life. Settlement date is T+2. Stock sold, cash in the bank 2 days later and we are out of here. Sods law says it will probably be the wrong time to sell but do you honestly think I could care less what the prices are?

Yes, I agree with you. One has to think about opportunity cost of keeping too much money in non stocks. It would almost be better for those building up assets for retirement to not know there current portfolio balance but rather only know the current annual income stream produced. Personally I agree with your advice, remembering to keep a few years spending in cash set aside, not as an “investment” but more as a means of getting a good nights sleep.

I also have a portfolio of approx 45% equities, 50% high yield Corporate Bonds (Both USD and AUD) a RMBS 5% cash and an overseas property and am very comfortable with this mix. Since switching some of my portfolio into corporate bonds some 6 years ago my returns have stabilised and improved. Given my experiences in 1987 and 2007 I would not go back to an all equities portfolio again.

Pity William. There is a thing called 'opportunity cost'. It can be very expensive.

I love this straightforward and simple mindset approach to investing. I agree with other commenters that it works well as long as you have a suitable buffer between your share income and expenses. I am however curious about how an individual could replicate the performance of that chart? From what I can tell there is no ASX200 industrials etf or fund available at present, how do others invest for the long term in industrial shares? Individual stock picking?

I will declare my hand. I use the old fashioned listed investment companies (LIC's).
My rules of thumb are few. 1. they must have been around for a minimum of 50+ years.
2. The management must be integral, i.e. I don't want an external manager taking fees to run it. There are 4 that I use here. One of them is 100% industrials whilst the other 3 have holdings in the top 4 or 5 resource companies which I'm not fussed about.
I have a notable holding amongst my UK investments (a legacy of working there for 18 years) it is a listed investment that has been around for over 100 years. It has just celebrated its 51st year of consecutive dividend increase.
I DO NOT care about prices.

Thanks Peter, for your involvement and comments. I assume you referring to AFI, ARG and MLT? Do you think that in the current era of technological disruption it would be risky to rely on Australian assets exclusively?

I know we are a backwater but I don't think technology will bypass us.
What is the risk of relying on Australian assets? By default I have overseas investments in the UK having worked there for 18 years: I do not invest in the US. Taking the lazy way out, I look at the shareholdings we have via direct and Listed Investment Companies and many of the companies are global although listed on the Australian and UK Stock Exchanges . Cochlear and CSL would be two ASX standouts. We make do with that.

For the sake of the discussion and without promoting, necessarily, either alternative points of view, it is worth reading this article. The benefits of time diversification it seems are in the eye of the beholder.
<em>What Practitioners Need to Know... About Time Diversification https://www.cfapubs.org/doi/pdf/10.2469/faj.v71.n1.4</em>

It's easy to ignore the inherent volatility in shares - that is, right up until you need the money.

While on paper every retiree is better off in an all share portfolio, at some point in the future many retirees are going to need a large sum of money to get them through the door at a nursing home or similar. If that time in your life happens to coincide with a 30% market fall, you may well regret your 100% equities exposure.

Personally I prefer portfolios with a mix of shares, hybrid securities, listed corporate bonds, first mortgages and direct commercial property. The returns are not very different from an all-share portfolio and the risk-adjusted return is probably even better.

Horses for courses as they say Justin. Retirees are not better off on paper with a share portfolio: They are better off in real terms. I don't know what you are worried about. Nursing homes aren't a problem! As I indicated above, my mother was hamstrung with cash deposits.
Having a husband who was incapacitated after the war she managed to raise four children and pay off the war service loan used to buy our family home. After Dads death she simply sold it and moved into a retirement village until she died recently at 97. Our only regret on her behalf was her 100% cash exposure.
I can assure you that a mixed portfolio is not going to outperform shares and as for 'risk adjusted return', I refer you to my remarks in the article about volatility. It does not measure risk. It is merely an outcome of the extraordinary liquidity associated with shares.

Can I also add that we turned on our pensions in 2007 at the time of the GFC. I always look forward to market downturns; the bigger the better.

A great message. Life cycle funds were designed to eliminate advisers, but in reality a lot of them a disaster for investors. Just don't write off high quality first mortgage investments &amp; commercial property. They all have a place alongside shares. Give bonds a miss though.

Steve, bonds are a medium term investment so people who expect to draw down on their capital within 3-5 years have a place for bonds, as a capital stable component.

It’s irresponsible for an adviser to make blanket statements like “avoid bonds” without any qualification about individual circumstances. For most it might be true - though read the article I linked to in my Guest Editing about high yield bonds - but not for all.

It just highlights the need for good advice. Risk is mainly in the eye of the beholder. If all options are explained well, than investors can come to a logical conclusion and one that suits them. Personality, ability to comprehend complex issues, etc all play a role in that decision. There is effectively no right or wrong in this event. But ego's get caught up in measuring outcomes constantly, and often over inappropriate time frames and at selective points in time which don't tell the whole story, often making people feel inferior or as if they are missing out on something, leading to them to stray from their original conclusion ( emotional discipline is a big factor). Hence, find good advice or do lots of your own research and know yourself well before investing anything. And then make subtle adjustments, not great leaps from black to white if you learn something new you accept.

I still have a version of that chart on the wall of my office. Does anyone know where I can get an updated one?

Email me Steve and I'll send you a copy.

Hi Peter,
We would also appreciate a copy of the chart mentioned above - ie risk of bond yields

Peter Thornhill has a point. I read Motivated Money in 2008 as part of my re-consideration of asset allocation, having lost half my share capital.
The comparison of shares and dividends with cash and term deposits doesn't present the complete picture however. The option of corporate bonds should also be considered in determining risk and asset allocation.
Whenever commentators talk of "bonds" they inevitably refer to US treasuries, Gilts and Bunds. Sure, fixed rate bonds are "risky" in a rising interest rate environment. They are inevitably purchased way above face value and are often very long term.
But, high yield corporate bonds and RMBS, purchased close to face value can provide an income that matches the total performance of Australian shares and dividends. And the coupons and capital returns turn up predictably. Our super has returned 10.7% over the past 17 years with 45% corporate bonds for the last 8 years. Telstra is my totem for the risk of relying on shares for growth and income.

I agree Peter, they are a legitimate investment alternative that could fit within a diversified income portfolio. However, I consider they come with a few fleas.

If they are fixed rate then you know the income for the duration of the bond so the real income return of the bond will vary depending on inflation.

As you say they are normally purchased at close to face value therefore the capital growth potential is limited to the amount of the discount if they are held to maturity.

Perhaps movements in risk free bond rates and credit spreads will affect the market value on the way through and this may provide opportunities for trading profits. However, at this point in time I would be treating any fixed coupon investment with extreme caution. With interest rates at unprecedented lows, any increase in interest rates is going to have a severe impact on these investments.

Of course the liquidity in some of the corporate bonds may not be great and this may also impact the trading price.

If they are higher yielding there is probably a good reason and therefore the investor needs to be very comfortable with the credit risk. I would encourage you to revisit the chapter in my book on the 'Yield Trap'.

We have only managed 15% p.a. over the last 17 years aided by a fabulous tailwind provided by the GFC.

Peter, I am grateful to a friend of mine in the Listed Investment Company arena for the following comments.
"Corporate or Higher Yield Bonds are most properly considered a higher risk asset class.

When economic conditions are good, there are very few defaults on the bonds, and investors receive the benefit of the high interest rates paid.

When economic conditions deteriorate, some of the bonds will default resulting in a full or partial loss to bond holders. In addition, because the risk of default increases in these situations, the market value of the bonds will also deteriorate, meaning that those wishing to sell such bonds can only do so at poor prices.

In financial terms, the higher interest rate paid represents the compensation for the estimated cost of those defaults. For example, in very rough terms - a Corporate Bond Portfolio offering interest rates 4% higher than government bonds would be expected to suffer defaults equivalent to 40% of the portfolio value every 10 years.

The most unfortunate element for bond holders, however is that the risk of default is not evenly spread over the security life. Instead the risk is clustered around the periods when the poor economic conditions apply. The implications of this are that such bonds are low risk for some years, but carry extremely high risk in others. (For eg, in the situation above, the 40% loss of capital may well occur in just one year).

Widespread Corporate Bond collapses are common throughout history. The GFC is the most recent example (2008). There was the Savings and Loan Crisis (1980s), the High Yield Bond Market Crash (1989), the Dot-Com Crash in 2001. That’s an average of one per decade.

For exactly these reasons, it would be fair to say that ASIC and most other global regulators are particularly concerned about investors misunderstanding the true risk of high yield investments.

The secondary reason he received 10% per year over the last few years, is that bond yields fell to historic lows with the result that the market value of bonds rises.

The opposite occurs as bond yields rise – the market value of bonds falls.

As any forecaster will point out, the risk of bond yields rising and producing a bond market collapse is currently the largest single risk overhanging investment markets."

I always have two concerns about a share-dominated portfolio:
1. It is more suitable for rich people - less wealthy people may not receive enough dividends to cover their expenses and then may need to realise assets. This is when volatility matters.
2. It is ultimately an article for Australian shares in retirement. This means the strategy comes with all the problems of a concentrated index, etc

Gary, from first hand experience, I think I can safely say that the less wealthy people need this strategy more than the wealthy. If you refer back to my chart, our family's experience was as follows. My father died in 1980, where my chart begins and, doing the 'conservative' thing, what little money there was remained on deposit.
Subsequently, my mothers income followed the red bars for the next 37 years whilst her cost of living followed the yellow bars. With the benefit of hindsight I look back and think; what if!
Whilst volatility of share prices may make the headlines; it does not matter over the long term as Warren Buffett as pointed out rather eloquently. It is the income one receives that matters.

If Dividends are 'not enough' - what alternative investment would suit these people?

Everything else would provide a lesser return, with less tax advantages and bigger issues I would have thought.