Beware the hidden risks in a 'safe' strategy
Nobody likes low returns on any investment. We know inflation runs about 2.5 per cent, so you need to earn at least 4 per cent to get anywhere.
But where do returns come from? They are a reward for taking risk with your money, and the opportunity cost of not using that money, either for consumption or other types of investment.
In low interest-rate environments, we often hear that retirees should buy high-yielding shares to get adequate returns. What we seldom hear is a discussion of the risks posed by this strategy.
Some might say, "What risk? I only invest in 'safe' high-yielding shares." The reality is these are hard to find. They might look safe through the prism of long-term averages, where the equity-risk premium shines through. But a lot of retirees don't have long horizons, even though they might be in retirement a long time.
Because retirees generally need to spend some of their capital on a regular basis to finance their retirement, they are exposed to a market risk called sequencing risk. This is the risk you get from a poor run of returns while drawing on your capital. Take this example: a 10 per cent rise in the market value of a $250,000 share portfolio, followed by a 10 per cent fall, doesn't put you back square. You have actually lost money: 1 per cent (or $2500), to be precise (a 10 per cent loss on your gained value of $275,000 takes you back to $247,500). If you kept getting this sequence of returns (while having to spend say $10,000 a year to live on), you would burn through your savings quickly.
Also, with shares, your investment return comes from movements in their market value, as well as the dividends. The swings in market value can be significant. Let's say you bought 10,000 XYZ shares looking for a dividend yield of exactly 5 per cent, ignoring franking. XYZ has an annualised standard deviation of total returns of 20 per cent. If you were expecting an investment return of 10 per cent (that is 5 per cent dividend and 5 per cent capital growth) in an average year, the price could swing between minus 15 per cent and plus 25 per cent. This equates to a monthly volatility figure of almost 6 per cent which is more than your annual dividend yield. In an average month, you are risking your whole year's income. The same thing the next month and so on.
So, when investing in volatile assets such as shares, the overall risk you are taking can quickly negate the attractive-looking yield.
This is not to say equities should be avoided in retirement. Retirees need growth assets and should seek income through franking benefits. But they need to understand the risks in the pursuit of these apparently more attractive returns.
As someone once said, there is no such thing as a free lunch.
Jeremy Cooper is chairman of retirement income at Challenger Limited.