The reality of negative returns - knowledge is power - Episode 66

Episode 66 – The reality of negative returns - knowledge is power

Investment markets don’t always go up.

In fact they go down on a pretty regular basis.

Is that a shock to you? I suspect not.

Yet virtually none of the commentary on investing talks about negative returns – markets going down.

But when I speak with clients, especially new clients, usually somewhere in their top 3 issues is not wanting to lose money – hardly surprising!

So in today’s post, let’s bust open this taboo subject and talk openly about the reality of negative returns.

So you’re about to start investing. Your driver is the goal of growing your savings – building wealth, and with that comes the choices in life that is our central theme here at Financial Autonomy.

But you would be unusual if you didn’t worry about losing your money. Mountains of behavioural finance research tells us that we humans fell loses much more powerfully than we enjoy equivalent gains.

So let’s look at the realities. If you invest in a portfolio that is either 100% Australian shares, or 100% International shares, the data indicates you will experience a loss roughly 1 on every 4 years.

Now most people actually invest in a mix of assets – shares, both local and international, some property, and usually some conservative assets like cash and bonds.

For a typical Growth type investor, where the bulk of their assets are in shares and property, the likelihood of a negative return becomes around 1 in every 5 years.

A more conservative Balanced investor would be looking at closer to a negative return 1 in every 7 years.

Just a side note here – when I talk about a Balanced portfolio, I mean roughly 50% in growth assets like shares and property, and 50% in defensive assets like cash and bonds. You will find that some super funds offer a Balanced option, but when you look at the asset allocation it is far more heavily weighted to the growth assets – often it looks like a 70/30 split, which is more like a Growth allocation.

I just wanted to highlight that because it’s a real problem in the investment industry – mislabelling of products. Don’t assume that the Balanced option in your super fund has the 1 in 7 chance of a negative year. Take a look at how they invest your savings, and if it’s weighted towards the growth assets, recognise that your chance of a negative year is likely to be closer to 1 in 5.

Now most in the Financial Autonomy community are in the building wealth phase and retirement is not imminent, so I’m going to work from here on the assumption you’re going to invest in a Growth type mix of assets, and that means you should see a negative return about 1 in every 5 years.

Of course if you find that uncomfortable, you can invest more conservatively, and reduce that frequency. You might also want to take the risk level down a notch or two if your time frame is shorter – say 3 or 4 years.

But here’s the key takeaway for you today – for Growth investors, 4 out of every 5 years, the value of their investments will go up. And that is a totally fine outcome.

What you want is a good outcome over the medium to long term. Short-term ups and downs don’t matter, so long as you have structured things so you’re not forced to sell at a bad time.

To illustrate this, consider two investors. One can’t tolerate any years where there’s a loss. So the solution for them is to invest in cash. Now they find an online savings account that pays pretty good interest, so let’s say they earn 2%.

The other investor, whilst not a gambler, can tolerate a few ups and downs. So they invest in a typical Growth mix.

Now I’ve grabbed the data for the past 10 years – the year ending December 2008 to the year ending December 2017. Now the Growth mix sure enough had 2 years that were negative, 2008 and 2011. As investment experiences go, and investor that kicked off at the start of 2008 had about the worst start imaginable, with markets diving and so a return that year of negative 20% - a big fall in year 1 is the worst result you can get.

But even with this absolutely horrible start, the growth investor still did better than the Cash investor. After 10 years in fact, and based on an initial $50,000 investment, the Growth investor would be over $20,000 better off than the cash investor.

They’ve been paid $20,000 as compensation for putting up with occasional negative returns.

And that’s a hugely important concept for you to grasp. Provided your portfolio is appropriately diversified, you get paid to take on risk. The reason the Cash investor only gets 2% is because their only risk is the bank going broke – fortunately very improbable in Australia.

The Growth investor, by being prepared to tolerate the ups and downs of markets, comes out significantly ahead.

Now there will be some listening who will think “well, if my investments are going to experience negative return roughly one in every 5 years, I’ll try and pick the bad year, and pull out my investments. Then when things look better, I’ll go back in.

Tempting though this sounds, it is disastrous.

Do you know that professional fund managers in the US, who have nothing else to do all day but try and beat the market, succeed only about 15% after costs over 5 years? In our active managers have done a little better with about 33% succeeding.

If most investment professionals can’t get market timing right, what is that chances you will do better?

You might recall some other research that I quoted which found that whilst investors could have earned 7.2% over 20 years by simply buying and holding the US share market index, the average actual return for investors was 5.3%. Why did investors earn less on average? Trying to jump in and out of the market.

So to spell things out really simply, forget about trying to time the market – it will only cost you money.

In a similar vein, armed with the knowledge that, if you’re a Growth investor, you will inevitably have years where the value of your investments go down, recognise that the key during these periods is to not sell.

Sure, the value of your account might be lower, but you still have the same assets, and so long as you don’t sell, history tells us that prices will recover. This is what I’m referring to with the sub-headline – Knowledge is Power. By entering into your investment journey well aware that there will be years of market falls, you can (hopefully) withstand the urge to race to the exit at precisely the wrong time.

To wrap up just remember, positive returns 4 out of every 5 years is a totally acceptable and satisfactory outcome. Indeed, an acceptance of this will make you far wealthier than an investor who requires their investment to rise every single year.

If you’re keen to start investing, download our free toolkit – Investing – How to get started. It covers risk and reward, share market basics, the 12 most common investment mistakes, and tips on gearing to manage risk.

And of course if you’d like some help and support building an investment portfolio – well that’s what we do! So check out the Work with Paul page.

Here’s some other investment related posts that you might find of value:

Investment basics – Active vs Passive – what it’s about and our approach

Investment power-ups