Strategies for volatile markets

By Scott Francis, Author, High Income Investing

It is the toughest of times for investors. Sharemarkets are sharply down, and yet history shows that they have the capacity to recover - and recover quickly. The risk of selling now is missing that recovery.

Many investors who have sold think that they will come back once things improve, but the reality is that "once things improve" markets would have already jumped on a positive outlook.

It feels like being stuck between a rock and a hard place. This risk of being out of the market is a real one that can destroy wealth for investors.

The risk of "timing" markets

Dalbar, a United States financial services firm, produces an annual report that outlines the success rate of the average managed fund investor in shares in the United States. Between 1985 and 2006 the average managed fund investor received a return of 3.90 per cent, against a return of 11.9 per cent from the index (the average market return). Why is this return so low? Primarily, because investors do a terrible job deciding when to buy into and sell out of asset classes.

When share values are falling, there is a strong tendency for investors to want to sell assets. When share values have risen strongly, the tendency is to want to buy more assets. This is effectively "buying high" and "selling low" - the opposite of what a good investor should do.  The results - with the average investor receiving less than one third of the returns on offer from the market - are spectacularly bad. This is a key plank in the argument that investors should thoughtfully build an asset allocation and then stick to it.

Index return (S&P500) vs. average return for a
US managed fund investor 1985-2006 

If a picture is worth a thousand words, this chart represents thousands of dollars wasted by investors, trying to pick and choose when to get into and out of shares - when the only thing that they really needed to do was to stay invested in shares over the long run to have a really successful and profitable investment experience.

So, rather than try to "pick and time" investment , how should we cope with a volatile market?

Building an effective asset allocation

Step one: Fixed interest and cash exposure

For most investors the returns from fixed interest and cash are not particularly attractive at the moment. The best cash management trusts and online cash accounts are returning just over 7 per cent. This return is completely taxable, with investors on the highest tax rate losing almost half in tax.  The returns from fixed interest investments, such as term deposits - assuming that you are not indulging in the risky world of unsecured notes, debentures and non-investment grade bonds - is not much more attractive. Similar to cash, the return is tax-ineffective.

So why would we ever incorporate cash and fixed interest returns into a portfolio?

There are two main reasons: to provide liquidity; and to dampen volatility in the portfolio. Liquidity refers to the ability of an investor to access cash from their portfolio -having enough cash and high-quality fixed interest.

Fixed interest and cash also "dampen" the volatility in a portfolio. Let's compare two portfolios, one made up of 100 per cent growth assets and one made up of 50 per cent growth assets.

In the 1987 sharemarket crash, growth assets - Australian shares, listed property, international shares - fell in value by about 35 per cent. For people who had 100 per cent of their investments in growth assets, their portfolio fell in value by that 35 per cent. For people with just 50 per cent of their investments in growth assets, their portfolio fell in value by just 17.5 per cent.

Reducing volatility sounds great, but there is a risk involved in putting too much a proportion of your assets in defensive investments. The risk is that the investment earnings from defensive assets are so low that the returns from your portfolio don't effectively keep pace with inflation.

The balance comes down to the inevitable investment trade-off between risk (volatility of growth assets) and reward (higher investment returns). Once you have decided how much of your portfolio to apportion between defensive and growth assets, the next step is to decide which proportion of growth assets to hold in your portfolio.

Step two: Growth asset classes

The three main growth asset classes I use in investor portfolios are Australian shares, international shares and listed property trusts.

Direct residential property, also a legitimate growth asset class, tends not to be incorporated into the portfolios I use for clients because:

• Most clients already have direct property exposure through their residence.
• Exposure usually involves borrowing, which is not suitable for many of the clients who are close to retirement.
• The current yield on direct residential property is fairly low, and therefore doesn't provide an attractive income stream for funding retirement.

So how does a portfolio get the correct balance between Australian shares, international shares and listed property trusts? The following graph shows the average annual returns from each growth asset class in the 26 years between 1 July 1980, and 30 June 2006.

Growth asset classes, average annual returns 1980-2006* 

* Australian shares returns are based on the All Ordinaries Accumulation Index; international shares on the MSCI World Index Accumulation Index; and listed property trusts on the ASX Listed Property Trust Accumulation Index. 

The reason we start at 1980 is because listed property trusts began only in the 1970s, and the listed property trust index is reported from 1980.

What is clear is that the returns from the three growth asset classes are very similar, with only a 1.06 per cent difference between them over a long period. It is this similarity of returns that suggests the basis of the growth asset allocation of a portfolio should be exposure to all three growth asset classes, because they produce similar investment returns.

Being exposed to all three will reduce the overall volatility of the portfolio, because as one asset class does poorly the other two might be able to compensate. Of course, there will still be times - such as 1987-88 - when all three growth asset classes produce negative returns. Interestingly, this is the only year since July 1980 when that has happened.

So should the assets be simply allocated 33 per cent to each growth asset class?

There is a case to favour Australian shares, as the income paid by Australian shares includes the tax benefit of franking credits. There is research that suggests this benefit is not priced by the market and provides a "bonus" return. On this basis, an allocation of 60 per cent to Australian shares, 25 per cent to international shares and 15 per cent to listed property trusts is reasonable.

Asset allocation in practice

Let us take the example of a couple, about to retire, with $700,000 in assets.

They decide that they need $40,000 a year for living expenses and want to put seven years of income ($280,000) aside in defensive assets such as cash and high-quality fixed interest investments, knowing that they these assets will be secure. This will let them sleep at night without having to worry about where the next few years' income will come from.

This equates to having 40 per cent of the assets in defensive investments. It also means that if there were some sort of economic shock and growth assets fell in value by 30 per cent, their portfolio would fall in value by about 18 per cent, and that they are comfortable with this level of volatility.

Within the defensive assets, they want to keep $70,000 in cash, preferring the immediate liquidity that it offers, along with reasonable current returns of 5.5 to 6 per cent a year. This equates to 25 per cent of their fixed-interest investments. The remaining 75 per cent of their defensive assets ($210,000) is invested in high-quality fixed interest investments, targeting a slightly higher earning rate than the cash rate.

Within the growth assets, they agree with allocating 60 per cent ($252,000) to Australian shares, 25 per cent ($105,000) to international shares and 15 per cent to listed property trusts ($63,000).

Conclusion

There is no doubt that this is a difficult time for investors. However, a longer-term focus on the asset allocation of their portfolio can take their attention away from the short-term volatility, allowing them to be confident that they have the cash and fixed interest investments that allow them to meet their medium-term living costs, and the share and property investments that allow them to benefit from the higher long-term returns from growth assets.

About the author

Scott Francis is an independent financial planner, whose practice A Clear Direction Financial Planning is based in Brisbane. He has written the book High Income Investing, published by Wilkinson Publishing.  He is a fortnightly commentator on ABC weekend radio in Queensland.

(This article can also be found on the ASX website)