Risk is real

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%.

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

A Approximately two-thirds.

Q3. Have both Ten Year Bonds and the ASX Property Trust Accumulation Index outperformed the All Ordinaries Accumulation Index over the twenty years to 31/12/2000?

A Yes, producing 28% and 48% more profit respectively (see Graph 1). Property averaged 14.4% pa, bonds 13.6% pa and shares 12.4% pa. 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 '87 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 '87 and pass the performance of the average mortgage trust?

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

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

A. 1st 20-40% growth assets (11.4% pa); 2nd 40-60% growth assets (10.3% pa); 3rd 60-80% growth assets (8.5% pa).

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% respectively (see Graph 3).

All fund performance data uses Morningstar indices.

The American stockmarket lost 18% of its capital value over a 17.25 year period. If calendar years were used, the Dow Jones Price Index produced a 0% return from 1965 through 1981.

In real terms these were losses of 74% and 67% respectively.

As financial planners, do we warn our clients that major stockmarkets can lose capital value over almost twenty 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 looks like it could be worse. It would have to recover exceptionally strongly to end up with a loss of only 18% over seventeen years.

It took more than eight years before our market passed and remained above its pre '87 crash level. If you were meeting with clients six monthly this would involve 16 review meetings at which you reminded them that it was a long term strategy.

In each of these cases I am analysing capital return only.

Turning to total return if, before the Crash of '87 you'd put 100% of a portfolio into humble, "low returning" mortgage trusts, the return would have run all over "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 ISG's history we have placed more money in stocks than in property or interest bearing securities and consider this justified.

The fact that markets decline over five, ten and fifteen year periods does not mean we should not recommend equities.

However, when we do so we should:

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

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

Only allocate such a proportion of a portfolio as the client is comfortable to have to withstand this situation. This could be 100% 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

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 '87 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 or less likely than a repeat of a best case scenario like the 1,413% pa growth produced by the Dow Jones over the 16.4 years from 11/8/83 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 sharemarket investors after the 1987 Crash, or property investors in 1991 whose property trust unit values had fallen by up to 100%, 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 shows 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% in equities - despite the truism that 100% in any asset class is as extreme as it can get. I promise you that after the next stockmarket 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 those of alternatives. If we represent such investments to clients as if there is no doubt that they will make the most money we are fooling at least one of ourselves or the client.

If we can't be certain, we should advise accordingly.

It has been forgotten that to beanti-excessive, risk is to beproreturn. A big loss can set your client's financial strategy back five or ten, or even seventeen 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.

Rob Keavney is the managing director of Investor Security Group (ISG).