Tortoise always wins in super race

Tortoise always wins in super race
Chris Becker
November 23, 2011 - 12:01PM

 

Retirement may come sooner than your super fund's recovery. Photo: ThinkStock

We all bemoan the state of our super when we open our statements each year particularly given the rolling ongoing crises that beset the share market. Yet the common wisdom is to always look to the long term and eschew focusing on the short-term gyrations.

You've probably heard that to fund your retirement, your super fund should return inflation plus three per cent. To achieve this, you've been told to allocate nearly three quarters of your retirement savings into growth assets, mainly shares, or you will miss out on their growth and have your savings eroded by inflation.

The reality is most super funds cannot achieve this performance nor capture the upside potential - "they're dreaming" - as Darryl Kerrigan once put it.

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According to SuperRatings, the average return for the 50 largest "balanced" super funds over the last five years is 1 per cent per year. Over a 10-year period it averages 5.1 per cent per year. Across all types of super funds (except self managed), returns have averaged 3.3 per cent per year - or just 0.3 per cent above inflation. Dreaming indeed. The problem is further compounded because the averages hide the inevitable volatility that comes with "investing" in growth assets.

In your writer's previous report, Time to rethink your super,  (also available here as "Tackle Risk for Super Returns"), we looked at a different technique to overcome the dual problem of underperformance and volatility - the barbell portfolio.

First, your super is for saving, not speculating, and should mainly comprise solid investments like bonds, term deposits and annuities. Secondly, you should still have exposure to growth assets, but you must consider the risk before the potential return as the long term implications are devastating to your retirement savings.

The tortoise and the hare

Here's the reason why the downside matters more than the upside. Imagine two portfolios - the tortoise and the hare. The hare is your typical "balanced" fund, with over 70 per cent assets in shares and property, the rest in cash and fixed interest. Over a thirty-year period, the hare will experience some "fast" years, earning well over 10 per cent, and occasionally will fall into a puddle, earning nothing or losing a few per cent.

Not so often, by not looking where he is going, he falls into a deep hole, losing 20-40 per cent of the portfolio. He climbs out and sets off again. The Tortoise takes a different path, avoiding the holes and puddles, plodding along, always earning between 4 and 8 per cent year in, year out. But “on average” the hare should win, right?

The reality is the hare hasn't understood time and opportunity cost. To get back to even after a 20 per cent loss - a common occurrence in the last 4 years - requires a 25 per cent positive return. Even if he has successive 10 per cent returns each year, it will take him 8 years in a row to catch up to the hare earning a positive 6 per cent year in, year out. And that's without falling into any more puddles or holes.

Compare the funds

So let's compare some real world performance. Assume a starting balance of $100,000 in 2001 in a balanced and a barbell portfolio, where the latter has a 90/10 weighting of “investment” and “speculative” assets. The former will comprise a third cash, two thirds bonds, the latter only an Australian share index fund.

The real potential behind the barbell portfolio is twofold. First, it outperforms the balanced fund by 23 per cent, by averaging a little more than the required 6 per cent a year (3 per cent plus inflation). More importantly, it smoothes the returns by limiting the downside volatility, with a maximum drawdown of 2 per cent, compared to almost 13 per cent for the balanced fund (remember this is an average over a 12 month period.

In reality, the typical balance fund dropped over 20 per cent in value during the GFC. Not a good time to retire.)

This absolute return allows peace of mind for retirees and avoids the “hare” problem for accumulators. How to do it

The basic barbell portfolio described above can be easily constructed with the required investment options available within the most popular retail and industry super funds.

Remember the allocation, the vast majority of your fund should be in secure "investment" assets with almost zero potential for drawdown or loss of capital. Most funds have a "cash" option and a "bonds" or "fixed interest" option available. Consider a bias to the latter, e.g up to 60 per cent in bonds, as the top 25 diversified fixed-interest funds have returned at least 5 per cent per annum over the last 10 years. Some funds will even have a "term deposit" option, which could return as much as 6 per cent per annum.

The speculative side of the barbell - no more than 10 per cent - would be best allocated to Australian shares only. I would not consider international shares, due to the structural inability of fund managers to provide even a positive return over a 10-year period. A small amount in property or infrastructure - even up to 5 per cent - could be considered due to the income stream, but remember these assets are extremely risky and illiquid.

Don't forget security - the bar that binds the two together. In a non-DIY fund, the best security asset is life and disability insurance where the costs are usually much cheaper due to the group discounts within the fund.

Conclusion

Relying on market volatility and traditional asset allocation to provide the return in your super has been shown as unreliable even in the biggest bull market in history.

Regardless of market conditions, either blue skies or impending doom, you need constant positive or “absolute” returns to both build and protect your precious retirement savings.

Chris Becker writes as The Prince at MacroBusiness. He is a full-time equities trader as well as a partner in Empire Investing, a private value investing company. The full MacroBusiness "The tortoise route to riches" report is available free at MacroBusiness, as is the "Tackle risk for super returns" report.

Read more: http://www.smh.com.au/business/tortoise-always-wins-in-super-race-20111123-1ntod.html#ixzz1eXhAAUP1