The concept of retirement, as we understand it today, is completely outdated.

Wait a minute, did I say completely outdated? I mean completely, ridiculously, totally, absurdly outdated. It wasn’t a good idea when Otto Von Bismarck, the chancellor of Germany, cooked it up, and it’s certainly not a good idea now.

In 1881, Bismarck designed a plan for retirement, hoping to defuse a threat from Marxists, who were gaining popularity throughout Europe. The plan was carried out in 1891 with the age initially set at 70; it was lowered to 65 in 1916. At the time, most potential pensioners would be dead by 65. Smart politics then, perhaps, but bad policy now. If you reach 65 today, according to the Social Security Administration, you can expect to live around 20 more years. But we can’t exactly blame Bismarck for not being forward thinking enough — it was 135 years ago!

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But adults often forget.

For instance, we may stop pretending to be superheroes, but a lot of us seem convinced that we can pretend to be investors. That’s dangerous.

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That’s the thought that went through my head high over the ocean, willing the plane to go faster as I rushed thousands of miles back to New Zealand to meet up with my gravely injured wife in the hospital near Christchurch.

Let me back up…

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If you said Warren Buffett or the retired Fidelity ace Peter Lynch, you’re wrong. The famous speaker is Numbers.

That’s right, Numbers.

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When the new adviser asked why it was invested that way, the client replied, “It’s the way my current adviser said the money needed to be invested.”
After spending considerable time to make a thorough diagnosis, the adviser suggested his client invest much more conservatively. It turns out that this particular individual had way more money than he would ever need. It could have been in cash, earning close to nothing, and he’d still meet his goals.

When he suggested the change, the client said, “You can do that?” It was the first time someone took the time to link his actual goals (low-risk investments and maintaining a steady income stream from them) to how his money was invested.

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Value stocks underperformed growth stocks by a material margin in the US last year. However, the magnitude and duration of the recent negative value premium are not unprecedented. This column reviews a previous period when challenging performance caused many to question the benefits of value investing. The subsequent results serve as a reminder about the importance of discipline.

Measured by the difference between the Russell 1000 Growth and Russell 1000 Value indices, value stocks delivered the weakest relative performance in seven years. Moreover, as of year-end 2015, value stocks returned less than growth stocks over the past one, three, five, 10 and 13 years.

Unsurprisingly, some investors with a value tilt to their portfolios are finding their patience sorely tested. We suspect at least a few will find these results sufficiently discouraging and may contemplate abandoning value stocks entirely.

Total Return for 12 Months Ending 31 December 2015
Russell 1000 Growth Index: 5.67%
Russell 1000 Value Index: −3.83%
Value minus Growth: −9.49%

Before taking such a big step, let’s review a previous period when value strategies underperformed to gain some perspective.

As many growth stocks and technology-related firms soared in value in the mid- to late 1990s, value strategies delivered positive returns but fell far behind in the relative performance race. At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15 and 20 years. The inception of the Russell indices was January 1979, so all the available data (20 years) from the most widely followed benchmarks indicated superior performance for growth stocks. To some investors, it seemed foolish for money managers to hold “old economy” stocks like Caterpillar (−3.1% total return for 1998) while “new economy” stocks like Yahoo! Inc. appeared to be the wave of the future (743% total return for 1998).

Many value-oriented managers counselled patience, but for them the worst was yet to come. In 1999, growth stocks shone even brighter as value trailed by the largest calendar year margin in the history of the Russell indices—over 25%.

Total Return for 1999
Russell 1000 Growth Index: 33.16%
Russell 1000 Value Index: 7.36%
Value minus Growth: −25.80%

In the first quarter of 2000, growth stocks bolted out of the gate and streaked to a 7% return while value stocks returned only 0.48%. As at 31 March 2000, value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years and by 1.49% per year since the inception of the Russell indices in 1979. AWall Street Journal article appearing in January profiled a prominent value-oriented fund manager who regularly received angry letters and email messages; his fund shareholders ridiculed him for avoiding technology-related investments. Two months later he was replaced as portfolio manager amidst persistent shareholder redemptions.

With value stocks falling so far behind in the relative performance race, it seemed plausible that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year.

By November 2000, value stocks had delivered modestly higher returns than growth stocks since index inception (21 years, 11 months). By month-end February 2001, value stocks had outperformed growth over the previous one, three, five, 10 and 20 years and since-inception periods.

The reversal was dramatic. Over the period April 2000 to November, value stocks outperformed growth stocks by 26.7% and by 39.7% from April 2000 to February 2001.

This type of result is not confined to the technology boom-and-bust experience of the late 1990s. Although less pronounced, a similar reversal took place following a lengthy period of value stock underperformance ending in December 1991.

We can find similar evidence with other premiums:

• From January 1995 to December 1999, the annualised size premium was negative by approximately 963 basis points (bps), amounting to a cumulative total return difference of approximately 113%. Within the next 18 months, the entire cumulative difference had been made up.

• From January 1995 to December 2001, the annualised size premium was positive by approximately 157 bps.

The moral of the story?

Prices are difficult to predict at either the individual security level or the asset class level and dramatic changes in relative performance can take place in a short period of time.

While there is a sound economic rationale and empirical evidence to support our expectation that value stocks will outperform growth stocks and small caps will outperform large caps over longer periods, we know that value and small caps can underperform over any given period. Results from previous periods reinforce the importance of discipline in pursuing these premiums.

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Yet in your mind you can picture three or four faces.  These are clients that seem to consume the news and, when the market reaches certain thresholds, they become unnerved.

They are unnerved for a simple reason.  In their mind a pattern has formed.  Their hidden belief is that because the market has gone down 10%, then it will go down another X% (fill in the blank with 5%, 10%, 15% or what have you).

In other words, they don’t mind so much that the market has gone down, but they mind a lot about where they think it’s going to go.

We can’t really blame them.  Humans are programmed to form patterns – this is why we see constellations in the stars.  As Wall Street Journal personal finance columnist Jason Zweig says in his fantastic book Your Money and Your Brain, “After two repetitions of a stimulus – like, say, a stock price that goes up one penny twice in a row – the human brain automatically, unconsciously, and uncontrollably expects a third repetition”.

This behaviour is everywhere, but it especially hurts us with money.  Consider how many fortunes have been blown in the casinos of the world because the gambler thought they were on a ‘hot streak’.  Rolling consecutive sevens in craps or hitting 21 on consecutive hands in blackjack makes us think, for some reason, that the next seven or 21 is more likely than it really is.

Carl Richard illustrates the phenomenon this way:

How do we counteract this behavioural bias?  By being relentless with the truth.  And the truth is this: a recent down turn in the market never has, and never will, be any predictor at all of future negative returns.  The graph below shows the how the market performed 12 months, 24 months and 36 months after market falls of varying magnitudes from a previous market high point.

Across the board the median case is that markets were positive after any size drop.  Looking at the upper and lower quartiles shows a distribution of results is possible (of course) but it’s mostly positive.  We use the S&P 500 to take this illustration all the way back to World War II.

Salient for current markets, the median returns after the markets have fallen 10% is a positive 8.19% for the next 12 months, which is right around what the market returns on average anyway.

As advisers, it may be useful to show this chart to clients so they can read the facts, but perhaps it’s even more useful to memorise the facts for ourselves.  How powerful is it if, over the phone, you can say, “I know you’re concerned, Joe, but since the end of World War II, the market has lost 10% from a previous high a total of 14 times.  In those cases, the median return 12 months later was 8.19%.  Based on that, I don’t think we should read too much into recent performance.”

Of course, there is another approach.  An adviser we work with recently told us they say to clients who ask, “I know the market just lost 10%.  Isn’t it great?”

“What?” says the client, slightly exasperated.

“Listen, if the market didn’t ever go down then we would never earn the premium for owning shares, and without the premium for owning shares we’d never reach our financial goals.  We need volatility!  Don’t worry, we haven’t taken on any more volatility than you can handle”.

“Oh, ok” says the client, and changes the subject.

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So, what are the pros and cons of each option, and what criteria should matter most to investors?

In this article we discuss a range of criteria, and provide some insights gained from our activities in the domestic fixed interest market.

Does the investment provide the risk and return exposure that is sought, given the investor’s risk appetite and investment objectives?

Investors tend to seek fixed interest as an asset class for its traditional characteristics of income, as well as capital stability. They do this because fixed interest tends to offset the volatility experienced by shares. To offset share volatility effectively, fixed interest investments should be made up exclusively of investment grade bonds (rated between AAA and BBB- on the S&P scale). When share prices fall investors tend to flock to Investment grade securities, pushing up their price. Their price rise offsets the price fall in shares. This cannot be relied on with high yield securities, as investors discovered with the New Zealand finance company collapses.

Here’s the important point – to raise the likelihood of fixed interest investments providing capital stability, diversification is required. An investor who utilises individual securities rather than a fund will likely be limited to only a small number of issuers. In a concentrated portfolio, default, or a significant downgrade by a single issuer, can severely undermine returns at the time the portfolio needs those returns the most.

Again, the failure of finance companies in New Zealand from 2007 – 2010 is a reminder of both the pitfalls of sub-investment grade securities and, in many cases, poor diversification.

For example, below we show the returns of our New Zealand equity strategy in 2007 and 2008 (the heart of the Global Financial Crisis) and a blended portfolio of 50% equities and 50% fixed interest. Note that all returns listed below are after relevant investment management fees.

All returns are net of investment management fees but gross of advice, custodial and transaction costs. Past performance is not indicative of future results. For details on our NZ equity and fixed interest strategy please see consiliumnz.co.nz/disclosure-statement. This clearly shows the potential of a properly diversified investment grade portfolio of fixed interest to offset the volatility of shares at exactly the right time.

Can investors achieve diversification in New Zealand fixed income?

While global fixed interest markets offer significantly greater scope for diversification, it is also possible to achieve a reasonable degree of diversification in New Zealand. It is easier to do this with a fund rather than by selecting direct securities. This is because there are some corporate issuers that only issue to the wholesale market, meaning retail investors cannot buy these securities. If we exclude small local authorities, there are over 90 different issuers available to wholesale investors in New Zealand. Of these, only around 30 can be bought by retail investors directly.

Another challenge for buying New Zealand fixed interest directly is opportunities to invest in new issues. As the number of securities in New Zealand is limited, new issues are very important. A fund can more flexibly and easily add new issues into a broadly diversified portfolio because it can accommodate varying maturity dates and credit qualities. Those buying direct will naturally have more specific maturity, issuer and credit quality requirements, meaning that new issues cannot be easily incorporated into their portfolio.

What costs are involved?

Of course, there is a management fee cost to owning a fund. We pay less than 0.40% for our direct New Zealand fixed interest funds. It’s worth noting that investing in fixed interest via a managed fund actually lowers costs in two important (but often unaccounted for) ways. Firstly, funds pay lower brokerage costs to transact on the exchange, and secondly, funds simply pay less for the same bond via a narrower bid/offer spread for trades not dealt on the exchange. We estimate that these savings are around 0.25% at the time of purchase.

Are there other benefits from professional management?

Fund managers may also be able to add some additional value to help offset their costs. This will vary across funds, depending on the capabilities of the fund manager and the design and investment approach of the fund. As an example, for the three years to June 2015 the Harbour NZ Corporate Bond Fund has generated about 0.12% p.a. of added value over the ANZ Corporate Investment Grade Bond Index, before costs. The relevant issue is perhaps not the 0.12% cost offset, but that no investor buying bonds directly could ever hope to achieve the diversification of the ANZ Corporate Investment Grade Bond Index without incurring very high transaction and monitoring costs. The fact that Harbour can do so, and add a little something back, is a great benefit to investors.

Even if you don’t believe that managers can add value through professional management, their research resources may help avoid the accidents that can occur in small, poorly researched portfolios.

Can term deposits be a solution?

Term deposits (TDs) often provide a higher running yield than a bond fund (after fees) or direct securities (after costs). There is a good argument for holding some exposure to TDs, but they also have different characteristics. Investors typically choose short maturity TDs, of less than one year, because of the severe penalties that occur with early withdrawal. The short length of the TDs may offset the potential added return. To underline this issue, the Reserve Bank and APRA, the Australian regulator, have required Australian banks, and their New Zealand branches or subsidiaries, to tighten up the conditions under which investors can break a TD before maturity. This lack of liquidity may be a problem at times for investors.

Secondly, since TDs have no price mechanism, they do not increase in capital value at times when shares fall, meaning we lose some of the diversification benefit we are seeking through fixed interest securities.

What am I paying my adviser to be an expert in – financial planning or bond markets?

The Code of Professional Conduct requires an authorised financial adviser (AFA) to “make recommendations only in relation to financial products that have been analysed by the AFA to a level that provides a reasonable basis for any such recommendation, or analysed by another person upon whose analysis it is reasonable, in all circumstances, for the AFA to rely.” In our experience, it is a challenge for most advisers to bring together the expertise and resources required to satisfy this requirement in relation to directly held securities. In our view advisers are, and should be, experts in financial planning rather than experts in fixed interest markets. Those who try to be both risk doing both to a lesser standard.

There are several factors to consider when choosing between funds or direct investments in New Zealand fixed interest. Financial planners are accustomed to using funds for investing in equities and overseas asset classes. We believe the underlying investment characteristics of an appropriate fund can be a better proposition than direct securities, due to a fund’s ability to achieve diversification, liquidity and benefit from professional management.

We’d like to thank Harbour Asset Management’s Mark Brown for his assistance with this article.

Important notice and disclaimer

This commentary is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that any such content constitutes advice, it does not take into account any person’s particular financial situation or goals, and accordingly, does not constitute personalised financial advice under the Financial Advisers Act 2008, nor does it constitute advice of a legal, tax, accounting or other nature to any person. The bond market is volatile. The price, value and income derived from investments may fluctuate in that values can go down as well as up, and investors may get back less than originally invested. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. No person guarantees the performance of funds monitored by Consilium NZ Limited.

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Imagine for a moment that you own an insurance company and your entire portfolio is made up of ten very big policies, all paying you healthy premiums.  Imagine also that you know a lot about your insured policy holders, and you feel confident about each policy.

But, being a responsible person, you hire an actuary to take a look at your risks.  After careful examination, the actuary comes to you in a panic.

“You’ve got a big problem” he says.  “A few of those claims going wrong could really hurt you.”

Then he adds some grist to his words.  “You only have a small number of large policies.  Most of the insured risks are from the same area and it is possible one big event could affect multiple claimants at once.  In other words, the risks between policies are correlated.”

“Correlated?” you say.

“Yes,” he responds, “It means that a risk affecting one can affect others.  The problem for you is that one rare event could bring this company down.”

It’s clear you’re unimpressed.  The actuary continues, undeterred.

“Your portfolio of policies is completely under diversified, breaking the first rule of risk management.  Let me put it this way – you could make a killing, get average results or get killed.  But the chances of getting killed are way too high!”

You don’t like the sound of getting killed.  “What’s the solution?” you ask.

The actuary responds, “Obviously, you need more policies; smaller policies, from more locations with different and less correlated risks.”

This story isn’t just hypothetical.  In 2011 AMI Insurance held 35% of the market share in fire and general insurance in Christchurch.  Clearly, the risks on those policies were correlated, in so far as one event affected nearly all policy holders at the same time.  AMI had the audacity to allude to the fact that they were victims of their own success…but equally they were victims of their own hubrisregarding risk control.

What’s the connection to a portfolio of investments?

Well there is quite a strong connection if your share portfolio includes only a dozen or so New Zealand shares and a few from Australia.  A portfolio concentrated in such a way is susceptible to two big risks:

• A sudden reversal in the fortunes and price of any one business you own.
• Something happening in New Zealand that seriously affects the profitability of all businesses in this country (they’re called recessions).

Like an insurance company that wants to control risk, you don’t want a few huge holdings.  You want thousands of small holdings (shares) in your portfolio, across dozens of countries and hundreds of different industries.

This is exactly what a diversified asset class portfolio offers.

You know that some of those businesses will fail or deliver very poor returns, but it doesn’t matter, because any one company is only a miniscule part of your portfolio.

Similarly, an insurance company with a diversified group of policies understands that someone will make a claim, and they have spread the risk of that eventuality so that the impact will be minimal.

This approach, while making perfect sense from a risk perspective, has one important drawback.  Whilst it removes the chance that your portfolio will get ‘wiped out’ by some inevitable poor returns, it simultaneously removes the chance that you will make a killing.

It essentially destroys the potential of a get rich quick event, but if that’s your game, why have a dozen or so shares?  Just pick your favourite one and pray…

Of course you wouldn’t insure your home with a company that had such a foolish strategy.   Why would you insure your future that way?

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We’ve been asked why shares are so volatile.  Hopefully this explanation will help.

Shares represent ownership in business.  Shareholders have a claim on the profits the business makes – these profits are paid out as dividends, or reinvested into the company in order to grow future profits.

The most basic model of valuing shares takes both of these inputs – dividends and growth (by growth, we mean growth in profits) – and combines them in an equation to form a price.

The model states that Price (P) equals the next dividend (D₁) divided by my required return (r) minus my expected growth (g).

Put together, the model looks like this:

Let’s try out the model.  We’ll say next year’s dividend is going to be $0.25 per share.  Let’s say I require a 10% return on my investment to make it worth my while, and let’s also say I expected dividends to grow at 4% per year into the future.

The model would say the price =

An investor with the assumptions above would be willing to pay $4.17 for shares.

Now, let’s alter the growth assumptions.  We’ll run one scenario where growth is 3% and another where it’s 5%.

5% growth:

3% growth:

A 1% change in growth doesn’t seem like a big deal – the company is profitable in either case – yet a 1% increase in the growth projection translated into a $0.83/$4.17 = 20% increase in price.  A 1% fall in the growth projection caused a 14% fall in price.

The point of this is to illustrate that changes in projections about future growth (even small ones) can cause big changes in prices.  In the real world, there’s a lot of disagreement about the growth potential of businesses.  This disagreement is good, as it creates willing buyers and sellers.  When buyers and sellers come to some agreement that growth prospects have improved or worsened, prices will move pretty quickly to adjust.

Should you only invest in businesses with high projected growth?

One conclusion you may be tempted to make is to only invest in businesses with high growth forecasts.

That would be the wrong conclusion.

One thing this model points out to us is that an investor should really be indifferent between an investment with 3% growth, an investment with 4% growth and an investment with 5% growth.

Why?

In each case, the price adjusts, so an investor could expect roughly the same return with any of the three growth projections.  What this means is that great companies are not always great investments, and bad companies are not always bad investments.  The important thing to consider is what you are paying to invest in either.  At the right price, you are indifferent.  In fact, evidence suggests that investments with low prices provide higher returns over the long run, even though they often have low growth projections.  This is probably because these companies have poor prospects and investors require higher returns (a higher r from the equation above) to own them.  At any rate, the model helps us understand why this would be the case.

Hopefully this has helped you understand why markets concern themselves so much with growth, and why prices can move so much and so quickly, as well as.  It should also have explained why price movements are so important.  They reset the investment equation so that firms with very different growth potential are actually comparable investments.

How would prices change if growth projections stayed constant?

While the above is useful, it may leave you with the impression that growth rates have to increase for you to get a positive return on your investment.

That isn’t the case.  Prices will still increase in a world where there is no change in growth projections.

Why?

Let’s say that growth doesn’t change.  It stays at a forecasted 4%.  What would happen to prices in that world?

Even in that case we can expect prices to appreciate because of two things:

• In this world, you received the dividend
• In this world, you achieved the forecasted growth

If growth was 4%, next year’s dividend would not be $0.25.  It would be $0.25 plus 4% growth.  It would be $0.26.

Doing the same equation as above, a business with a $0.26 dividend, 4% projected growth and 10% required rate of return would translate into a price of $4.33.  That’s around a 4% increase from $4.17.

You then add your dividend yield to this gain, which is the dividend divided by the price.

Add them together: 4% (capital gain) + 6% (dividend yield) = 10% (return).

Thus, in the default world the price will go up every year, and you’ll get that 10% return every year.  Of course, we also know that rarely occurs.  Economic cycles, business decisions, interest rates and a host of other things each year influence the prospects of businesses to grow profits.  And, if both buyers and sellers agree that growth projections have changed, prices will change quickly to reflect this fact.

By looking at investments this way you can see why shares have an expected return, where that return comes from and that it does not require improvements in forecasted growth to achieve the expected return.

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