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I suspect that this may be common to many investors right now. Although her experience is very real, part of it is illusion and part is reality. Hopefully, understanding the difference can help regular investors stay the course.
The first mechanism in play is the "illusion of volatility suppression through regular savings". It sounds complicated but the concept is quite simple.
When we first start a regular savings programme, the contributions that we make often form most of the growth that we observe. Even if investment markets are negative, it is possible that the contributions you have made will still ensure that after 12 months, your closing balance will be higher than your opening balance. When this happens, you are experiencing the illusion of growth, even if your investment return had not been positive. This phenomenon is further enhanced if your employer and the Government are also contributing. This is one of the reasons that investors quickly developed confidence in KiwiSaver.
However, when investment balances build up, the relative proportion of our annual contributions reduce. In these circumstances, when investment markets temporarily decline, the reduction in the capital base can be greater than your contributions. In this case, the investor will see their capital balance reduce. The potential for this to occur naturally increases as your portfolio grows.
I must stress that this illusion is not a negative thing; it allows many investors to continue to invest at times when they may have otherwise stopped through a loss of faith in markets or just general worry.
The other advantage of this phenomenon is that it allows investors to gain the benefit of something called "dollar-cost averaging". This is the term that describes the advantage that regular investors gain when markets fall, because their regular contributions are buying shares and bonds when their value is temporarily depressed (i.e. effectively on sale). Interestingly, we instinctively buy consumer products when they are "on sale", but not so much with financial assets!
The second mechanism that is driving an increase in the volatility has come about as a direct result of our low interest rate environment.
In the past, a traditional "moderate" risk portfolio may have held 40% in cash and bonds with 60% held in growth assets (including property and shares). Historically, the relatively high returns that could be achieved from bonds provided a foundation of solid growth that was complemented by the more variable (but generally higher returns) from property and shares.
However, with cash and fixed interest rates being so low, many investors have increased their exposure to growth investments (listed property and shares). This increase is required to achieve their return objectives and also protect against the corrosive impacts of inflation.
As a result the stabilising influence of the bond part of the portfolio has been significantly reduced and the volatility of shareholdings is felt more acutely.
So what is the solution for my friend who is nearing retirement? My recommendations fall under three headings: understand, review and accept.
Understand that part of the increase in perceived volatility results from being a successful investor and having a larger portfolio. A female who reaches age 65 can expect to live to age 88. A successful retirement strategy is not just about investing to retirement, but involves investing through your retirement years.
Review the mix of investments in your portfolio and how it is being managed. I believe the old style of portfolio construction, which is limited to just being invested in shares and bonds alone, is not well suited to the changing world in which we live.
Accept that you may have to tolerate a higher degree of variation in the return of your portfolio (volatility) for periods of time. This is important for those in both the pre- and post- retirement phases. For those in the pre-retirement phase, you need to ensure that your capital is growing ahead of inflation. And for those in retirement, you need to be confident your retirement drawings can keep pace with inflation, and not run out before you do.
And beware of offerings that offer low volatility and high returns. From my experience, there is no such thing as a free lunch.
Peter Ashworth is a principal of New Zealand Funds Management Ltd, and is a Dunedin-based financial adviser. The opinions expressed in this column are his own and not necessarily those of his employer. His disclosure statements are available on request and free of charge.