Do equities always outperform in the long run?

Many financial planners have at best dim memories of the major corrections of 1994 and 1987. Rob Keavney believes some of these advisers are putting their clients into high-risk portfolios without really understanding what risk means.

If you are a financial planner who is really interested in the welfare of your clients, I hope you will read this article.

Let me begin with a test, and if none of the answers surprise you, don't bother reading on:

Q1. What was the return from the Dow Jones Industrial Share Price Index from 14/5/1965 to 11/8/1982?

A. A loss of 18 per cent.

Q2. How much has the Japanese Nikkei Dow fallen since its peak in December 1989?

A. About two-thirds.

Q3. Have both 10-year bonds and the ASX Property Trust Accumulation Index outperformed the All Ordinaries Accumulation Index over the 20 years to 31/12/2000?

A. Yes, producing 28 per cent and 48 per cent more profit respectively (see Chart 1). Property averaged 14.4 per cent, bonds 13.6 per cent and shares 12.4 per cent. The way to minimise return in Australia for the last two decades was to invest in shares.

Q4. How long did it take the All Ordinaries Price Index after the crash of 1987 to pass (and remain) above its level of 30/9/1987?

A. More than eight years.

Q5. If purchased on 30/9/1987, how long did it take for the performance of the average Australian equity trust to recover from the crash of 1987 and pass the performance of the average mortgage trust?

A. No-one knows because it hasn't happened yet (see Chart 2).

Q6. Rank the average performance of diversified unit trusts with 20-40 per cent growth assets, 40-60 per cent growth assets and 60-80 per cent growth assets over the past 14 years.

A. First, 20-40 per cent growth assets (11.4 per cent); Second, 40-60 per cent growth assets (10.3 per cent); Third, 60-80 per cent growth assets (8.5 per cent).

Q7. In what percentage of the last six years has the All Ordinaries produced a loss? In what percentage of the previous 14 years did it do so?

A. Zero and 50 per cent respectively (see Chart 3).

All fund performance data uses Morningstar indices.

The American stock market lost 18 per cent of its capital value over a 17.25 year period between 1965 and 1981. If calendar years were used, the Dow Jones Price Index produced a zero per cent return for the same period. In real terms, these were losses of 74 per cent and 67 per cent respectively.

As financial planners, do we warn our clients that major stock markets can lose capital value over 20-year periods; that they can fall by three-quarters in real terms? If I may ask a pointed question, do all financial planners recognise this themselves?

Of course, Japan at the moment looks like it could be worse than the US between 1965 and 1981. It would have to recover exceptionally strongly to end up with a loss of only 18 per cent over 17 years.

It took more than eight years before our market passed and remained above its pre 1987 crash level. If you were meeting with clients every six months, this would involve 16 review meetings at which you reminded them that it was a long-term strategy.

In each of the above cases, I am analysing capital return only. Turning to total return, if, before the crash of 1987, you put 100 per cent of a portfolio into humble mortgage trusts, the return would have run all over so-called high returning equities to this day.

The average Aussie share trust has also failed to catch up with the average bond fund (local or international), or even the average cash trust over this 13-year period.

If any of the above pieces of information is a surprise (or would be to our clients), then I would respectfully suggest that, as a profession, we need to ensure that we really understand the nature of the investments that we are recommending to clients, and fully explain it to them.

Advisers tend to say: "Equities outperform in the long-term." To the extent that this implies "always outperform", it is a false statement. It would be accurate to say: "More often than not, equities outperform but there can be periods of a decade or two where it doesn't occur."

I am certainly not arguing against the inclusion of shares in portfolios! Over Investor Security Group's (ISG) history, we have placed more money in stocks than in property or interest bearing securities and consider the strategy justified. The fact that markets decline over five, 10 and 15-year periods does not mean we should not recommend equities.

However, when we do so we should:

n Know the full range of possible outcomes - best to worst;

n Ensure our clients will not be surprised when the worst occurs by strongly warning them that such a risk is inherent in the strategy;

n Only allocate such a proportion of a portfolio as the client is comfortable to have to withstand this situation. This could be 100 per cent or close to it for some clients. I would venture the view, however, that this would be a very small proportion of informed investors; and

n Not speak of volatility as if this describes a kind of regular and minor variation around a steadily rising norm. It is dangerous to speak of downturns as if they are always short and quickly recovered from. This habit was fostered by the fact that 1994 was the only market decline in the experience of many advisers. In the long sweep of investment history, 1994 was a non-event, quickly recovered from.

If clients are forewarned we will be able to remind them, at the low point, that we have planned for this, preventing panicked selling at the bottom. If clients are not forewarned, they may feel deceived, crystallising a loss for their advisers via court edict.

However, some readers may want to find ways to dismiss the above periods as not being repeatable, say, with the explanation that the Dow Jones underperformance was "in the olden days", and that "Japan is culturally different", that the crash of 1987 was "exceptional" and other versions of "it can't happen here".

If we have a bias to optimism that filters the data we absorb, will it aid the quality of our advice? Recognising that we don't know the future, it would be irresponsible, not to say professionally negligent, to fail to recognise that what has happened in the past can happen again.

In fact, a repeat of a worse case scenario is statistically no more nor less likely than a repeat of a best case scenario like the 1,413 per cent growth produced by the Dow Jones over the 16.4 years from 11/8/1983 to 14/1/2000 (note, again this is capital return only).

Those few advisers with long enough experience to have sat across the desk from share market investors after the 1987 crash, or property investors in 1991 whose property trust unit values had fallen by up to 100 per cent, will not pass off volatility glibly, as if it is just a speed hump in a straight road.

Nor will they take much comfort in the reassurances that many advisers give, that "I've educated my clients about volatility", when it comes from individuals who themselves have never seen a severe downturn.

The recent industry funds flow figures show money overwhelmingly pouring into shares, mainly international, including lots of technology funds. As a profession, we are contributing to this.

It is not considered extreme to suggest that a young person, with a long time frame, should be 100 per cent in equities - despite the truism that 100 per cent in any asset class is as extreme as it can get. I promise you that after the next stock market downturn, this idea will disappear as a mainstream strategy, to be replaced by something equally unbalanced on the side of caution.

We are forgetting the plain English meaning of terms such as "high risk/high return". These words do not mean, "You will get a higher return". Any investments certain to produce a higher return is a lower risk investment.

A high risk/return investment is one in which the return can deviate widely - ie. it can be far better or far worse than alternatives. If we represent such investments to clients as if there is no doubt that they will make the most money, we are fooling ourselves and our clients. If we can't be certain, we should advise accordingly.

It has been forgotten that to be anti excessive risk is to be pro return. A big loss can set your client's financial strategy back five, 10 or even 17 years.

I acknowledge that some clients today, extraordinarily, are saying: "I am not taking enough risk with my money", although the words used for this are: "I'd like to increase my return." It is easy to acquiesce to such requests.

In the air force there is a saying: "There are old pilots and there are bold pilots but there are no old, bold pilots." As professional advisers, we need to remember that it is not our own plane we are guiding and it is full of passengers.