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Reality check for share bears - Eureka Report Article

January 30, 2008
Reality check for share bears
By Scott Francis

PORTFOLIO POINT: An extended period of poor returns on UK and US markets means returning to normal would actually bring an improvement.

The recent volatility in investment markets puts investors in the toughest battle there is: the battle with their emotions. In the doom and gloom of poor market returns there is a lot of pressure to make decisions. Should we sell? Should we buy more?

This article starts by looking at the question of a long term global bear market by looking at returns from global sharemarkets since the time the Dow Jones index broke the 10,000 point barrier in early 1999. It then looks at five realities as to how investment markets work. If you build an investment plan based on these realities, then the emotions of market volatility will be easier to cope with.

One of the definitions of a bear market that has been used during this market fall is that it is a fall of 20% in the value of markets. (We experienced a 20% fall from November 1 last year to last week's Black Tuesday, January 22.) A second definition of a bear market is a longer period of poor investment returns during a time of general pessimism surrounding markets - and this is the one that many investors fear: are we in for a long period of poor investment returns and general pessimism?

There are reasons to think not. As Alan Kohler explains today, the Australian economy seems in good shape, company earnings are strong and even though we have had a period of strong sharemarket returns, this seems to be propelled by strong company earnings growth rather than it being a bubble.

In Australia we have been in a unique position in recent times with an economy and company earnings pushed along by a resources boom. When we look away from our shores at the returns from global sharemarkets, the results are interesting. "Dow 10,000" was the term used to describe the first time the Dow Jones index went through 10,000 points, at the end of March 1999. Soon after that it passed 11,000. It is nearly eight years since the Dow first beat 10,000 points; as I write this it sits under 12,500 points (12,480). This is a total gain of about 25% over nearly an eight-year period - a disappointing return. Sure, there would be dividends paid to investors, but not as strong as the dividends paid in our market. The total return would be less than 5% a year over an extended period, well below the long-run return from US shares of 12.2% per annum since 1976.

What's more, these low-level returns are not restricted to the US. In 1999 the UK market's FTSE 100 index went though the 6000 point mark. Eight years on it is trading below that level.

The interesting thought is that there has now been an extended period of poor returns from overseas markets. If market returns show "reversion to the mean", then we should expect this period of poor returns in overseas markets to reverse to more normal, or even above-average returns. While in Australia there has been a feeling that we might be at the end of a bull market, the global evidence shows an extended period of poor returns. Maybe we should be talking more about the possible end of a global bear market, rather than the start of one.

In other words, our market outlook is very finely balanced: overseas markets have arguably been too weak; similarly Australian markets have been too strong. What should an investor do?

Whatever lies ahead, there are five investing "truths" that I believe never change regardless of sentiment.

Here are the five unchanging realities of investment:

1: Growth assets such as share investments and property investments are volatile

There are two groups of investments used in portfolios. The first are "defensive" investment assets, which include cash and high-quality fixed interest investments such as Australian government bonds. The second group are generally referred to as "growth" investment assets such as property and shares (both Australian and international). The returns from these asset classes are volatile. Figures compiled by Vanguard Investments show that in the past 30 years:
  • Annual Australian share returns have ranged between -29% (1982) and 74.3% (1980).
  • Annual global share returns have ranged between -23.5% (2002) and 72.7% (1983).
  • Annual listed property returns (Australia) range between -2.8% (1988) and 41.3% (1987).

2: Growth assets have a higher long-term expected return

Given that a good cash account provides a rate of return of above 6% in the current environment, why would you invest in growth assets at all? The answer to this is that growth assets have a significantly higher expected return than a cash or fixed interest investment.

nHow the returns compare
Investment % pa
Average Australian sharemarket return since 1971 13.8
Average global sharemarket return since 1971 13.6
Average listed property return since 1980 15.3
Average cash rate return since 1971 9.5
(Year to 30 June 2007, Vanguard Investments)

3: Volatility cannot be avoided

Wouldn't it be great if we could avoid the downtimes of investing in shares and property and only invest in them when they are increasing in value? It would be good, but it just doesn't happen. As an example, let's look at the biggest crash in recent Australian investment history in October 1987, when shares fell in value by more than 30%. Just before the crash more money than ever before was invested in the Australian sharemarket. The collective wisdom was that this was the best place to invest. The collective wisdom was absolutely wrong, as the sharemarket fall showed.

Dalbar, a US financial services firm, looks at the actual return investors in the US received from their managed fund investments. Over the 20 years to the start of 2006 they found that US managed fund investors received a return of just under 4%, against a market average return on the S&P 500 of 11.9%. Why did managed fund investors receive such a terrible return? Because they were trying to pick and choose when to invest and therefore avoid volatility, which seriously damaged their ending investment returns.

4: Growth assets can have negative periods of five-year returns

The collective wisdom in the financial services industry is that if you hold a growth investment for five years then you will get a positive investment return. This is easy to disprove: currently most global share investments (currency unhedged) are showing negative seven-year returns. Growth assets can have periods of negative returns for periods longer than five years.

5: Asset allocation and careful income planning is your key tool in managing volatility

Using a mix of growth assets in a portfolio, including Australian shares, global shares, listed property trusts, global listed property trusts and emerging market funds, smoothes (but does not eliminate) the volatility from growth assets. If you are very concerned about the future of the sharemarket you can always set aside a number of years worth of cash (the amount you feel you might need over a set period of time) and place those funds in fixed interest and cash investments so you will not have to sell growth assets in a market downturn.

Cash and fixed interest investments, which do not rise and fall along with the general market, also dampen the volatility of an overall portfolio. The cash and fixed interest investments are replenished by the growing stream of dividends and distributions from the growth assets, eliminating much of the need to sell growth assets at any time.


This is unquestionably a difficult period in which to be an investor. However, before losing all hope and deciding that a long-term bear market is on the cards there are many positive factors to keep in mind. These include the strong earnings from Australian companies and the generally robust state of the Australian economy - as well as the extended period of poor overseas market returns that we are seeing, which will have to reverse at some stage.

A focus on the reality of how investment markets work will help keep a market fall like this in the context of them being normal behaviour of investment markets; markets which, even with sharp drops from time to time, have delivered strong, long-term investment returns.