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The risk of underperforming

Aug 30 2017 09:39
Simon Brown

In response to a podcast I co-host, a listener wrote in to say that risk is not about the risk of losing money. 

Rather, the listener said, it is the risk of your expected return not being achieved, regardless of whether you lose money or not.

This is a great point and totally true. Sure, we worry a great deal about losing money. It keeps us awake at night. 

But if our money is growing at a rate below inflation or below the average market returns over an extended period of time, then we’re becoming poorer. 

While that’s not as bad as losing our money, it does have a very pronounced and negative impact on our investments and ultimately on our ability to retire (assuming retirement is the end game of investing).

I have often written that we need to make sure that we hold the majority of our investment in exchange-traded funds (ETFs) as this ensures we’ll get market returns.
 
Over the long term the market returns the best growth of any asset class. Holding a core of at least 50% in ETFs reduces the risk of returns not meeting expectations.
 
Of course, we could hold the wrong ETFs. Hence the next step is to ensure we have a small but diverse selection of ETFs covering different asset classes (stocks, property and debt) across different industries, geographies and currencies. 

This is very easy to do with just a few JSE-listed ETFs. 

This brings us to the next part of the equation: the individual shares we buy and hold.

The risk here is real and is simply that the stocks we buy underperform the market. Now your personal portfolio of shares may be returning, say, 10% but if the market is returning 13% over the same period you are falling behind and your retirement will be negatively impacted as we’ll have less money to retire on. 

This is the risk of not meeting expected returns.

Hence if we’re managing part of our portfolio ourselves or have a professional manager doing it, we need to measure our returns against the market, the benchmark. 

This needs to be the return after fees have been deducted. I measure my portfolio every year on a one-year and a three-year period. 

I may not beat the market every time but I need to do so at least two-thirds of the time. If I do not beat the market often enough, I should rather just put the money into a market-tracking ETF portfolio.

Finally, we get to the real and very large risk. What if market returns are lower than expected in general? We do everything right. 

We have a majority holding of ETFs, our individual shares beat the market more often than not. But still we did not do as well as we’d hoped simply because the market disappointed and hence we end up with less money come retirement.

Here we could try and delay retirement or find a new income stream in retirement, but this isn’t always an option.

So then, to mitigate the potential for lower returns, we simply need to save more. If the sums say that we should save, say, about 15% of our salary every month in order to retire comfortably, then actually we should save 20% in case returns are not as expected.

I remember buying my first retirement annuity (RA) in 1994 and being promised great returns – returns that never materialised. Now this was more because of excessive fees being charged, but the impact was the same.

The assumption made by the RA’s seller – that I would be able to retire as a man of leisure at 65 – was wrong. Fortunately I am not relying on it, otherwise I would have to work till I am 100.

This article originally appeared in the 24 August edition of finweekBuy and download the magazine here.

investment  |  investing  |  retirement  |  risk  |  etfs
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