Forget absolute returns

By Ian Davidson

PORTFOLIO VOLATILITY TABLE

$251,131.21 difference

Looking for investment gains? Well, first get rid of losses or reduce them before you can reap any gains

The investment industry has its own vocabulary to describe events or trends in the industry. For example, in the business, investment returns are described as having variability. So while investors are concerned with the everyday concepts of gains and losses and are very happy when their portfolios rise, they do not like “downward variability,” or more commonly called “losses.” And in order to reap investment gains, one must reduce losses. Take for example two $1-million portfolios. (Please see Portfolio volatility table, above.) Both portfolios have an average rate of return over 10 years of 8%.

Portfolio 1 is more volatile and has greater gains and losses; it is a proxy for a nondiversified portfolio such as the stocks that make up the S&P/TSX.

Portfolio 2 is diversified, made up of many asset classes. It often makes less money than Portfolio 1. In years where there are declines in Portfolio 1, there are no declines in Portfolio 2.

In Portfolio 1, three of the 10 years have losses, which took place in years three, five and nine. Years three and nine represent losses close to end periods and they dramatically reduce the growth of the portfolio. Losses are asymmetrical. So if the investor’s dollar declines by 20%, to 80¢, then the investor has to make 31% on his or her 80¢ to go back to $1. If we look at losses of 99% of individual stocks, such as Nortel, there is very little chance of recovery. We know investors’ emotions are also much more intense on losses than on gains.

In Portfolio 1, in years six, seven and eight, the returns are 12%, 35% and 25% and the three-year total is a huge 72%. These are the kinds of gains seen in a cyclical upturn. In 1998 through 2000 the large market gains were driven by the tech sector, and followed by a 41% peak to trough decline.

In the past three years, the Canadian stock market has provided large returns originating from just three sectors: oil and gas, minerals and financials. Of the 2005 Toronto Stock Exchange gains 60% was from oil and gas. Fossil fuel prices may rise forever, but they will not rise at the same rapid rate because inflation will rise and consumption will decline. In the first quarter of 2006, these three sectors were 75% of the TSX.

In the past 15 years, market volatility has increased. While increases in stock prices are rapid, declines are precipitous. It is very difficult for the retail investor to get out of a position in advance of the herd when the herd is not orderly.

Take the returns in years five through nine in the table on page 39. The returns are -15%, 12%, 35%, 25% and -20%. These rates of return mean that cumulative value of $1 from year five to year nine would be $1.28 in year nine even though the middle three years returned 72% in total.

If the year nine loss of -20% were to be smaller but of longer duration, say 7% a year for three years, this longer duration of losses would also depress the cumulative returns of the portfolio.

It is possible to reduce portfolio risk through diversification. Portfolio 1 is a proxy for investing in a group of stocks similar to those that make up the S&P/TSX. We can add asset classes such as short-term income, bonds, US equities, Canadian and US small cap equities, emerging markets and real estate. Not all these assets follow the same investment cycle. Good portfolio design reduces volatility by adding noncorrelating asset classes, which will also reduce returns in some years.

In years six, seven and eight, when Port-folio 1 returned 12%, 35% and 25%, the diversified portfolio in Portfolio 2 returned 10%, 18% and 12%. This underperformance is more than offset by the complete absence of losses in the three years when Portfolio 1 declined. In the real world, investors would be firing their advisers in these three years.

Everyone wants to be invited to the party. We can see that in year eight, Portfolio 2 earned 2% versus a loss of -20% in Portfolio 1. This is an outstanding performance of 22% but will still not be considered an invitation to the party by the average retail investor.

Using hindsight, the retail investor would like to earn 4% in fixed income. Diver­sifi­ca­tion does not mean that we can pick the right asset classes year by year.

What lessons can we learn?

You can largely ignore absolute returns. We see plenty of numbers in the financial media. Yes, if you invested $1 at exactly the specified period being measured, you would duplicate the results you see in a brochure or the newspaper. Most investors invest over time and not in one lump sum. Seldom do investment measurement periods coincide with those of the individual investor. Even a few days can make a significant difference.

Investment statistics are prone to end-period bias. Yes, income trusts averaged 20% a year for three years. Of course, they have only been around about three years. In October 2005, your income trust would have lost 10%. This one-month decline is not showcased in the three-year total return but it was unpleasant to retirees.

Some performance rating agencies stress recent returns in their star ratings. Three good years does not produce a five-star fund. You need 10 years and you need to see numbers for each of the 10 years. Compound returns for five years may be weak but 10-year compound returns look good. Six-year and seven-year numbers, if available, would also look weak. As they say in the prospectus, past returns are not predictive of future performance.

Going forward, a reasonable expectation will be for a portfolio to target 6% to 8% returns. Expected returns in a low-inflation and low-interest-rate world will be lower. Be prepared to make less.

You can increase your downside protection by adding different asset classes to your portfolio. Canada is only 2% of world equity markets and seldom outperforms the rest of the world. Yes the US dollar has declined and the S&P index has returned very little over seven years. Remember, if the US shuts down, so does every other economy in the world. Make sure you have bonds, cash, emerging markets and small caps.

You can also review the volatility measurements on mutual funds that are provided by such companies as Morningstar or Globe Hysales. Target higher-return, lower-risk mutual funds. Review best and worst period performance. Look at the investment style of the managers. Value and “growth at a reasonable price” style investors have lower volatility.

If absolute returns are not important, what is? Run to your neighborhood certified financial planner to prepare your financial plan. Look carefully at the amount of capital you need to reach financial independence and monitor it each year.

Didn’t like your investment returns for a period?

No problem. Add more money to your capital. Work longer. Reduce your retirement targets. Or, look more carefully at the after-tax income retention of your portfolio. Aim for capital gains and Canadian dividend income. Make sure you take advantage of income splitting.

Have your financial planner prepare an investment policy statement. It is a mathematical expression of expected returns of a given portfolio’s asset allocation and it will help you frame your expectations. You can manage your risk tolerance.

Popular media stresses absolute returns. But investment success is largely the absence or reduction of losses. Diversify your portfolio to improve your downside protection. Pay more attention to capital accumulation in your financial plan than to last year’s rate of return.

Ian Davidson, MBA, CFP, CA, RFP, is senior financial adviser and vice-president at Assante Capital Management Ltd. He is also the Technical editor of Personal financial planning