What goes up might come down
22 November 2015 | Investment principles
Time can be both friend and foe for investors.
It is your friend when there is time for the arithmetic of compound interest to work in your favor - or the ability to tune out a major market shock because the time that you plan to retire still can be measured in decades rather than months.
Whether you agree or not with Einstein about compound interest being the eighth wonder of the world, what cannot be disputed is the snowball effect that comes when you receive interest not only on your original investment but also on any interest, dividends and capital gains that accumulate.
Within superannuation there is the added boost that comes from the concessional tax treatment.
The maths of compounding is compelling and well demonstrated by the calculator on ASIC's Moneysmart site. Consider the case of two young people looking to build up savings for financial independence.
She invests $10,000 initially and adds $100 a month over 10 years. The interest rate is 5 per cent. At the end of the period it has grown to $31,998.
He defers savings for five years but then invests $10,000 but saves $200 a month.
They have both invested the same amount -$10,000- and added regular deposits of $12,000. But the extra five years of compounding interest means she has $31,998 to work with while he has to be satisfied with $26,435.
Time is the differentiating factor in this simple example. When it comes to superannuation the compounding is effectively baked in because the basic savings rate is mandatory and the funds are not accessible until you hit retirement.
So let us consider someone with 30 to 35 years of working life ahead of them until they hit retirement age. It is the asset allocation decision that will drive most of the portfolio's return and it is the time horizon that provides a level of freedom to add risk in the form of growth assets to a portfolio with the objective of capturing higher returns over the long run.
The bank cash rate is effectively the risk-free rate of return and when you look at Vanguard's index chart over the past 30 years the cash rate will have delivered you a 7.5 per cent return. By contrast Australian shares have delivered 10.8 per cent return over the same time period while international shares has delivered an 8.6 per cent return.
The difference between the cash returns and what share markets delivered at first glance might not appear that dramatic - particularly when you consider the extra risk and volatility of share markets in the past 30 years.
But thanks to the magic of compounding a $10,000 initial investment in Australian shares grew to $215,685, international shares to $118,257 while cash earnings compounded to be worth $86,815.
While the headline returns between the cash rate and the equity returns may not seem that different the critical issue is the wide spectrum of risk covered.
This is where investors need to choose the asset allocation and blend riskier asset classes with more conservative or defensive investments like cash and fixed income to suit their personal circumstances and risk appetite.
Typically younger folks can afford to take on more risk while people nearing retirement need to throttle back risk and focus more on capital security and income stream.
One of the more positive developments out of the public debate about the state of the superannuation system in recent years is the increasing focus on how the system can deliver better retirement income solutions.
Putting costs aside for the moment, the accumulation part of the Australian super system as it is now structured under the MySuper default deserves its position in the top rankings of pension systems globally.
However, while getting people to save a lump sum for retirement is an essential first step for any retirement savings system, simply leaving them to their own devices when they get there is likely to fall short in terms of achieving the best possible outcomes for fund members in retirement.
That was a key finding of the Financial System Inquiry chaired by David Murray and recently accepted by the federal government.
Recent research suggests that the average retirement age for men is 58 and 50 for women. If you were unlucky enough to retire just before the global financial crisis and your super was in a growth portfolio, then your retirement savings would have taken a significant hit. Academics describe this as sequencing risk.
In the real world, the need to withdraw regular amounts from your savings in order to pay the bills and put food on the table is when compounding becomes a negative. As you incrementally withdraw funds, you have less working to compound in your favour.
While markets recovered over the two years following the GFC an account balance that was being reduced by regular withdrawals effectively took a double hit.
This is not to suggest that at the point of retirement everyone should move their asset allocation on to an ultra-conservative footing such as cash or term deposits. Realistically, most people do not have super account balances large enough to not need some level of growth assets.
There are a range of strategies open to retirees to help manage both longevity (the chance you outlive your money) and investment risk.
Some financial advisers, for example, like to set aside about two years of living expenses in a cash fund to avoid the need to be a forced seller of assets in the event of a major market downturn. Others use a blend of income products like annuities to provide some level of income guarantee.
We are healthier and on average living longer - which is a good thing.
The wild card is we do not know how long we will live and therefore how long we need our money to last. Somewhat paradoxically, the evidence suggests that many retirees may be living overly frugal lifestyles because of the fear of exhausting their savings.
The debate on retirement income clearly has some way to run in terms of public policy settings - and may not affect today's retirees in any case.
That leaves those either in or approaching retirement today needing to navigate their own course to a large extent. If you can find specialist, professional advice to help advise and coach you through such a critical juncture, that is time and money worth investing. A good many self-managed super fund trustees are already forging the path here.
While Einstein suggested taking the time to understand compound interest what may be more appropriate for today's retirees is to understand the power of the asset allocation decision to match investment risk with your own, unique time horizon.
This article by Robin Bowerman originally appeared in the Australian Financial Review's Smart Investor section on 18 November.
Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
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Robin Bowerman, Principal, Market Strategy & Communications at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.