The silent killer of retirement savings

PORTFOLIO POINT: Slow and steady wins in wealth creation. Standard deviation might produce a higher average but fewer dollars.

It is a statistical certainty you don’t get excited about your portfolio or managed fund’s standard deviation but it could be positively catastrophic if neither your adviser nor fund manager cared. Why? Because this standard deviation, which measures the fluctuations of your investment return, is the “silent killer” of retirement savings.

Let me explain here what it is, why it is important and how you can manage it.

What would you rather have: a steady return of 9% every year or a higher fluctuating return averaging 10% a year? While the answer depends on the degree of fluctuation, most and especially pension funding investors should always look for low-volatility performance.

The table below illustrates why. It shows two lots of annual returns, the first where the return does not vary and the other where it fluctuates between good and bad. The first offers a simple average annual return of 9%, while the latter a larger 10%.

The “standard deviation” of the first series is nil while the latter is a much higher 20%. To put this into perspective, the standard deviation of the All Ordinaries accumulation index for the past five years was 16%.

After compounding, an example $100,000 initial investment would have grown to $236,736 after 10 years if earning a steady 9%. This is $17,492 more than the $219,245 from the more fluctuating return, despite it offering a higher simple average 10% return.

The calculated annual compounded or geometric return delivered over the 10 years is 9% for the first series and a disappointing 8.2% for the second series. The lower return given to the compounding accumulator investor reflects the fact that a 30% return after a 10% fall, or vice versa, does not give you 21% more after two years (10% times 10%) but a lesser 17%.

Taking this one step further, let’s consider a retired investor who starts with a $1 million portfolio and draws out a fixed $100,000 at the start of each year to live off. After 10 years the retiree who earned the steady 9% return would still have $711,334 left, while the retiree in the volatile portfolio would have only $459,891.

That’s a painful difference but not an obvious one when just looking at compounded growth returns.

Most investors know about “dollar cost averaging” and the benefits of regularly investing into volatile investments. However, few know about the cruel mathematics of retirement income funding where “reverse dollar cost averaging” comes into play. Instead of beneficially buying shares when they are temporarily cheap, retired investors often have to sell assets at depressed prices, leaving them with less capital to participate in a recovery.

Another unique feature of retirement funding is the timing factor, because the sequencing of good and bad returns is just as important. To illustrate, imagine if the second portfolio earned instead 30% in the first year then a negative 10% the next and continued to alternate. After 10 years of pension funding there would be $740,467, not a measly $459,891 (noting this reordered series still has a 10% simple and 8.2% compound annual return and would grow a $100,000 similarly).

This highlights that timing or sequencing of returns matters in retirement. It is far better to retire into a boom few years then a bust. As pointed out in a previous article (see Lifecycle investing and you) many retirees need to throttle back their equity exposure (and therefore their standard deviation) through a life stage investing strategy to avoid the chance of bad luck playing havoc with their quality of their retirement. I’m sorry if you are hearing this too late to make a difference.

Volatility of various Australian equity managed funds

Few fund managers and stockbrokers report the standard deviation of investments to retail investors. While this is probably due to lack of demand it is also for lack of understanding of its importance.

For the five years to March 31, the median annualised standard deviation of monthly returns for 532 (wow!) Australian equity funds is 16%. With more funds than stocks, it is not surprising this is the same average value for the ASX300 accumulation index.

For half of the funds, the standard deviation ranged between 15.3 and 17.3%. The most volatile fund had a whopping standard deviation of 36% (Perpetual Geared Australian share fund, which returned –4.6% annually) and the lowest volatility was 11.6% (Navra Blue Chip Australian Share fund, which returned 0.5% annually). This range is shown in the below figure’s horizontal axis. In the vertical axis, the annualised return over this same period is plotted. You can see that an increase in standard deviation, sometimes called risk, was not always rewarded.

Fund style was a big contributor to the risk and return performance. Geared funds were the most volatile and during this period delivered the lowest negative returns.

While the volatility of small company funds was an above average 20% during this studied period, they rewarded with the highest returns.

The top three performers adjusted for risk taken were Naos Emerging Companies (27% annual return for 31% volatility, click here), BT Microcap (23% return for 22% volatility) and Wilson HTM Priority Growth (20% return for 25% volatility).

The lowest volatility funds were many of those offered by value style and imputation/industrial share fund managers, mainly because many of these funds prefer stable income to fluctuating share prices. In addition to the Navra fund, some of the lowest volatility funds included Merlon Australian share Income fund, Investors Mutual Australian Share fund, Advance Imputation fund.

Although reliable they all underperformed the index, probably by avoiding low income resource stocks.

Some of the funds that beat the index’s annualised return of 3%, but at largely the same standard deviation, did so by employing special strategies. For instance, Aviva’s High Growth Share fund earned 6.2% annually but is able to short up to 25% of holdings. The Prime Value growth fund, which earned 5.5% annually, is allowed to also hold fixed interest and global equities.

Because about 90% of fund returns underperformed the “risk-free rate”, there isn’t much point subtracting the return from this theoretical benchmark and dividing the standard deviation to calculate the “Sharpe Ratio”, which tries to explain how much excess return was earned for unit of risk taken and is a good way to compare fund returns in normal times.

When looking at the range in fund returns and risk you might also note a left-edge, upward-sloping boundary where it was impossible to generate higher returns without taking on more risk. This is sometimes referred to as the “efficient frontier”.

If your fund is one of the few on this boundary then it is an efficient fund: it delivered the best return for risk taken. If instead your fund (or self-assembled share portfolio) is to the right of this line, your fund is inefficient; it means you earned less return than you should have for the risk taken. Of course there was one fund that would have been above and to the left of the efficient frontier and that was one run by Bernie Madoff. If the SEC investigators had read Eureka Report then perhaps he would not have ruined as many lives.

Volatility management

The most powerful way to reduce standard deviation is to add low volatility or stable priced assets into your portfolio. The following table shows the standard deviation over a longer 10 years for a series of Vanguard multi-sector funds that have varying allocation of growth and defensive investments. I’ve chosen these funds because their index style takes out the overlay of active fund manager volatility.

By constructing a portfolio with as much as 70% defensive assets, standard deviation can be driven down to a much steadier 3.4%. Normally this comes at the expense of return. However as these returns are through the recent GFC it also provides us with a reminder that equities don’t always beat bonds. Related to this strategy is the need to keep an eye on your asset allocation and rebalance in good times when your equity mix has risen too high.

Another way to reduce volatility is to blend in assets whose price or returns go in the opposite direction to others. Since high-credit quality, medium/long duration Australian bonds do and did go up in value during sharemarket crisis, they complement equities well. They do a better job than cash, whose capital value doesn’t change (and may in fact offer reduced income).

Commodity prices often go in different directions to non-resource company stocks and are sometimes used by portfolio constructors for this reason. Unfortunately, they usually come with an opportunity cost and bring their own high volatility.

You can also try to build volatility management into your stock portfolio by carefully selecting “negatively correlating” stocks. For instance, you might expect if the price of oil went up, so would returns from Woodside. That rise could compensate for losses on fuel buyer Toll Holdings. However, when oil prices fall then Toll might rally, making up for losses in Woodside.

A strategy of using options to generate higher income (from selling away price upside) should also provide lower volatility – as would paying for downside protection. Simply targeting higher income stocks might also reduce volatility, as finance theory suggests higher yielding stocks shouldn’t offer as much capital growth and hence price volatility. When chasing steady income be careful this doesn’t cause you to assemble a portfolio concentrated in just a few industry sectors.

With greater appreciation for delivering steady returns, rather than seeing managed fund labels like “high growth”, “high conviction”, “concentrated”, we might instead see funds marketed as “smooth”, “steady”, “consistent”, “diluted” and “boring”. Because when it comes to your retirement, its often better to be the tortoise than the hare.

Doug Turek is the managing director of the family wealth advisory firm Professional Wealth.