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Financial Happenings Blog
Tuesday, March 24 2009

In reading through The Australian wealth section this morning I came across an article written by Time Blue - Boomer to Busted.  The article as a whole was an interesting discussion of the impact of the current investment climate on those close to or in retirement.  However, the part of the article that drew my attention was the discussion of an academic paper written by Elroy Dimson, Paul Marsh & Mike Staunton - Irrational Optimism.

This paper looked at annual returns from the US and other international share markets from 1900 to the end of 2002.  Reading the article can provide a somewhat bleak view of future prospects from investing in equity markets with the authors suggesting you are an irrational optimist if you think it is totally safe to invest in equities even over a 20 year period.

Tim Blue's insights from the article was that the researchers found 7 occasions when it took at least 10 years for a full recovery in the value of equities in real terms (after taking out the impact of inflation).

Our firm's approach is that for investors who intend to draw down on their investments in the short to medium term, (e.g. retirees, those using transition to retirement strategies, those accessing income from the portfolio before retirement) we suggest that they hold 7 years of draw down requirements within their portfolio in lower volatility cash and fixed interest investments.  We base this suggestion on positioning clients so that they are protected from being forced to sell growth assets at values less than previous high points (currently November 2007 for Australian and international equities).

Why 7 years and not 10 years?  Those 7 years of cash and fixed interest will be supplemented by interest and dividend payments will push this window out past 10 years.

So what does this all mean?

If it takes 10 years from November 2007 to regain the high point, this means that an investor's asset allocation should be placed so that they are not forced to sell growth assets before the end of October 2017.  What real return would be required from equity investments to get back to this high point? - approximately 6.4% (i.e. if inflation averages 3%, the return from equities would need to be 9.4%)

This sits fairly nicely with Siegel's long term returns from equity markets

Alternatively though, according to Dimson et al, who see the real return from equities more likely to be 4% going forward this 10 year window pushes out to a 16 year window.  Based on this insight, for those with less tolerance to risk it might be that a portfolio is positioned with 10 years of cash and fixed interest to help protect against this eventuality.

For our firm, we think it is important for clients to be fully aware of these parameters and together with us make prudent decisions about asset allocation and investment decisions.

A final consideration that is often forgotten is defining what is the timeframe for the investment portfolio?  For most, an investment portfolio (don't forget superannuation) is required to last until death.  For many, the goal is to pass on assets to others at death whether it is to family or for philanthropic causes.  This pushes the time frame even further out.  Once you get out past a 20 year time frame, the certainty of having a positive outcome from investing in equities, although not certain, is definitely high.

In conclusion, our firm believes that investing in equities is a prudent approach over the long term.  However, expectations about these investments need to be based on realistic parameters and in relation to each individual client's preferences.

Regards,
Scott Keefer

For those interested in loooking into Dimson's research in more detail, through my CFA studies I have come across a webcast presented by Dimson in 2005 - Irrational Optimism.

Posted by: Scott Keefer AT 06:35 pm   |  Permalink   |  Email
 
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