Should you quit the market?

Selling shares now would mean selling low, missing income and likely good future returns.

PORTFOLIO POINT: Investors considering selling equities should think about what they might miss by doing so.

Just over four years ago the sharemarket was around 6800 points. Given average long-term price growth in shares (around 5% a year) it should be 8265 points now. In fact, it is about half that level – making it as difficult a period for sharemarket investors as there has been in Australia’s history.

On Monday Alan Kohler outlined his strategy for coping with the poor sharemarket returns, and various worries that exist in economies around the world – especially Europe. His solution was to reduce exposure to equities and, to show that he eats his own cooking, he has cut his self-managed super fund exposure to shares from 70% to 30%.

I don’t pretend to be able to forecast what markets are going to do. Indeed, there is plenty of evidence that people are generally poor forecasters of what is going to happen next. Even professional investors don’t seem to show “skill” when it comes to deciding which investment asset class will perform better or worse than any other; a famous study of US pension funds, entitled Determinants of Portfolio Performance and published in the Financial Analysts Journal looked at whether portfolio managers of US super funds were able to jump between asset classes and produce higher returns.

The study found that they were not. Other studies into market timing newsletters, which purport to tell investors when to jump into gold, cash, bonds or shares, found no evidence of skill in their advice.

In saying that it is difficult to time markets, it is interesting to note that one of the greatest investors of all time is Warren Buffett, and he does have a famous comment on market timing, telling people, “to be fearful when others are greedy, and only be greedy when others are fearful”. He has been a buyer of shares over the period of the European crisis to date – including bank shares.

If you accept that this evidence that timing markets is difficult, and many people do not, the question becomes how to deal with volatility. Kohler’s discussion of asset allocation is a great point to start. Various studies into how important asset allocation is to the overall returns from a portfolio find that it is the major driver of returns – Ibbotson and Kaplan published an article in the Financial Analysts Journal that the asset classes (eg, cash, shares, property, international shares) that a portfolio is exposed to is the key determinant of the portfolio returns.

Some time ago I looked at the maths of asset allocation for a simple portfolio split between shares and cash. I turned to Jeremy Siegel, of Wharton Business School and author of Stocks for the Long Run, who says shares seem to provide a return of about 7% a year above inflation (or a real return of 7% a year). Assuming inflation is 3% a year (a relatively big assumption), that is a total return for shares of 10% a year. In the Australian context we are fortunate enough to get an extra 1.5% a year from franking credits – a total return of 11.5% a year. We can use the long-run return for cash of about 5.5% a year.

The following table shows the expected return for each portfolio, based on average returns for both asset classes (11.5% a year for shares, 5.5% a year for cash), using different weightings of cash and shares. Of course, while the cash return is fairly reliable (it might fluctuate between 3% and 10% in normal circumstances and has almost no chance of being negative), the return from the share investments will be volatile, with 12 month returns between -50% and 50%.

-The equity effect
Shares
Cash
Portfolio return
100%
0%
11.50%
90%
10%
10.90%
80%
20%
10.30%
70%
30%
9.70%
60%
40%
9.10%
50%
50%
8.50%
40%
60%
7.90%
30%
70%
7.30%
20%
80%
6.70%
10%
90%
6.10%
0%
100%
5.50%

The point of this table is that a lower weighting to shares does not seem to reduce returns as much as some people might think. For example, moving from 70% shares to 30% shares reduces the expected portfolio return based on average returns from 9.7% to 7.3% a year. The “reward” for this lower return is a much less volatile portfolio, which many investors might appreciate. A long-run decision to reduce exposure to shares to decrease the anxiety that comes with portfolio volatility is an entirely rational one – so long as one eye is kept on the harm that inflation can do to a portfolio over time.

An interesting aspect to reducing share exposure at the moment is that you potentially harm the tax and income generated by your portfolio. The current income on shares is 4.75% a year, with franking credits likely to be worth an extra 1.5% a year. This is a total dividend 6.25% a year. Already good cash accounts are struggling to return much more than 5%, and this gap will fall further if there are further interest rate cuts. History has shown that, over time, dividends have tended to increase in value at about 5% to 6% a year – something that the interest from a cash investment will not do. This increasing income stream is important for growth assets (like shares and property) in acting as a hedge against inflation, helping the income from your portfolio grow as the prices of goods and services increase.

Part of the challenge for any investor is the tough time that we have been through – it is enough to make anyone want to forget about shares as an investment forever. Times were equally tough – and these are the most challenging in the history of the Australian sharemarket. Between January 1, 1971, and September 30, 1974, the total return from investing in Australian shares was –52%. A $10,000 investment more than halved in value. Over the following five years the return from shares was outstanding, from October 1, 1974, to September 30, 1979, the return was an extraordinary 29% pa.

Similarly, from October 1, 1987, to January 1, 1991, total return from investing in shares was –33%. From the January 1, 1991, to December 31, 1997, the return was an impressive 15.2% pa.

Putting figures together like these is a type of market timing in itself: trying to say that the recent years of poor returns will lead to better future returns. The point I want to make with these figures is not that returns will definitely be good in the future, but that reducing exposure to shares at the moment has the risk that a period of good returns will be mixed.

Another aspect to consider is, what information is already in the price of shares? Sure, the situation in Europe does not look good: the risk of sovereign default, high government debt levels and a possible recession. However, if share prices have already fallen in reaction to this poor outlook then shares will be fairly priced given these risks. While the media gets good mileage about the doom and gloom of this situation – and it is not a good situation – it is worth remembering that the world’s economies have coped with many recessions, government debt defaults (Argentina and Russia) and times of high debt.

Even in Australia we had a debt to GDP ratio at the start of the 1950s of about 120%, and yet Australia at that time was able to cope with this debt load. Again there is no suggestion that we are in the best of times, but with Australian shares down in value by more than 35% over a four-year period – where the usual expectation would be a price increase of more than 20% – there has to be a lot of bad news already factored into stock prices. In a recent Financial Times article, Burton Malkiel, Princeton economics professor and author of the book A Random Walk Down Wall Street, articulated a position that many people have: “We know markets overreact.” If markets do overreact, then it may just be a poor time to sell shares when there is so much bad news flying around for markets to concern themselves with.

Conclusion

This continues to be a difficult period for sharemarket investors, and given the worrying debt-fuelled headlines emanating from Europe there is every chance that throwing in the towel as a sharemarket investor seems to be a good strategy – and for people who want to reduce the volatility of their portfolio a lower allocation to shares might make a lot of sense. However, there are risks in making a decision to reduce share exposure in anticipation of further downturns.

While shares will inevitably be volatile, and downturns are part of the reality, selling shares at the moment would mean turning away from a relatively attractive income stream. It also risks missing a period of good returns – as happened after significant downturns in the 1970s and 1987. Even though the economic outlook looks concerning, the price of shares may well reflect all of this information and have even overreacted to it, meaning that selling now will be selling low.

Scott Francis is an independent financial adviser based in Brisbane.

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