The slump in investment markets has seen super funds post negative returns for a second financial year.
While very disconcerting, periodic negative returns from growth assets are normal and are the price we have to pay for the higher long term returns they provide.
Reacting to the current turmoil by moving to cash will lock in losses and only lead to lower long term returns.
According to the AMP’s Dr Shane Oliver, there are signs of improvement.
Share and credit markets led the way down and they are now leading on the way up as the global financial crisis is abating and leading economic indicators are pointing to an economic recovery ahead.
The key driver of returns for an investment portfolio is the asset classes in which it’s invested.
The most common diversified superannuation funds have 70 per cent of their funds invested in growth assets (mostly shares and property).
The logic is that over the long term, growth assets provide higher returns.
Of course this is not necessarily so in the short term and unfortunately over the last year most assets, except cash and government bonds, have had significant negative returns.
Even unlisted assets such as directly held commercial property, infrastructure and private equity have come under pressure.
As a result super funds have had a second financial year of losses.
After such a bad run the temptation is to think that cash is a better bet. However, there are several points to note.
Despite volatility, shares have higher long term returns
The first thing to note is that while shares provide a far more volatile ride than say cash or bonds they provide much higher returns over the long term.
This is evident in the next chart which compares the cumulative pre tax return from $100 invested in 1928 into each of Australian cash, government bonds and equities.
The chart starts in 1928 as I don’t have monthly returns for cash before then.
Note that it’s also a log scale otherwise the lines go exponentially up pretty quickly and look silly.
Over the whole period cash provides a relatively steady ride but only returns an average 5.4% pa such that $100 invested in 1928 would have grown to $6,879 today.
Australian government bonds are a bit more volatile and provide a slightly higher average return of 7% pa taking the $100 to $23,331 today.
By contrast Australian shares provide a rougher ride, but the benefit is that thanks to an average return of 11.5% pa, the $100 invested in 1928 would have grown to $668,625 today.
The point is that with shares we have to take the bad (periodic negative returns) with the good (higher long term average returns).
Over the last century shares have had numerous setbacks (1930s crash, the near 60% plunge in the 1970s, the 1987 crash, etc), but the market has always recovered to resume its rising trend.
Periodic negative returns in super funds are not nice but are normal
Secondly, periodic negative returns from a diversified mix of assets are normal.
Traditional diversified investment portfolios that underpin most superannuation funds aim to reduce the volatility associated with shares and other growth assets by having some exposure to cash and bonds.
But despite this the historical record indicates that traditional diversified portfolios (cash, bonds, property and equities) have negative returns every six years or so.
The next chart shows returns for balanced growth super funds from the Mercer Investment Consulting survey since 1982.
Since balanced super funds only came into existence thirty years ago, the chart also shows a simulated balanced fund.
This is constructed on the basis of 70 per cent in Australian equities, 25 per cent in Australian bonds and five per cent in cash.
The chart excludes exposure to global assets and property as we do not have a long term monthly return series for these.
In any case, going by the last 27 years it’s doubtful that it would change the pattern of returns dramatically.
The simulated series tracks the median Balanced Fund return pretty well suggesting that it’s a good proxy.
It’s clear from the chart that, while the losses over the last two years are extreme, they are comparable to experiences in the 1930s and 1970s, and more broadly it’s clear that negative returns every few years are a normal cyclical phenomenon.
Negative returns occurred in 1929-31 (Great Depression), 1938-39, 1941-42 (World War II), 1949, 1952, 1956, 1960- 61, 1964-65, 1970-71, 1972-74 (oil crisis, stagflation, Watergate, etc), 1981-82, 1987-88 (share market crash), 1990, 1994 (bond crash) and 2001-03 (tech wreck, terrorist attacks).
Equity market falls were a key factor in most of these episodes as were recessions.
The only way to avoid negative returns entirely would be to invest solely in cash, but this will result in much lower returns over the long term.
Mean reversion
Thirdly, average returns from superannuation funds over the 25 years to 2007 were well above what might reasonably considered to be sustainable.
Over the period 1901 to 2007 the average return from a mix of 70% in equities and 30% in bonds and cash is 5.5% pa after inflation.
By comparison the median real balanced growth superannuation fund return was more than 2% pa above this over the 1982 to 2007 period and between June 2003 and June 2007 real returns were more than double this.
In other words, inve
