Are investment returns becoming more elusive? In nominal terms, yes. But in real terms, maybe not so much. Possibly the single largest consequence of the Australian grand social experiment that is compulsory superannuation is that nearly everyone now has to decide how to invest financial assets over a very long term. What was previously the domain of a few is now a national occupation. In the current investment environment, it is an occupation that has lost a lot of its charm.
Debt, property and equity – the three main asset classes. When it comes to investment, classification of assets by class is useful up to a point. Individual assets within each class will share some similar characteristics. But groupings hide individual characteristics that can be wildly different. More so in equities than in debt, the alpha matters more than the beta, to use the modern portfolio theory terminology (is it so modern anymore? – ed note). Portfolios are often risk rated according to the proportion of assets held in each of these classes. Alpha is the stock-specific risk and beta is the asset class risk.
Debt assets, as a class, are suffering from the detrimental effects of central bank monetary stimulus. Government and semi-government debt assets are trading at near zero yields and there is alarming talk among some economists, who ought to know better, that negative interest rates are needed. That would make matters worse for longer. In corporate debt assets, yield prospects are better thanks to the variation of credit-worthiness so that market prices adjust accordingly. Credit-worthiness is akin to earnings prospects on the equity side. Property, commercial and industrial, is very much alpha dependent. The real estate agent mantra – location, location, location – also applies to commercial and industrial property, along with rental levels, vacancy rates, quality of tenants and so on. But as an asset class, debt is unattractive and will remain so until interest rates return to natural levels.
At the weekend backyard barbeque, the discussion may start off with the latest cricket scores, Richmond’s prospects for another AFL flag in 2020 and why the Wallabies are hopeless but inevitably moves on to investment. Remember the key purpose of investment is to secure an income stream to match, with a high level of certainty, future expense outgo. Hence, estimating future expenses and needs is the first step in investment. Securing the necessities of life, food, housing, clothing and heating should be the first priority. Then healthcare can be brought into the equation, hobbies and pastimes, bequests, luxuries and so on. Greater risk can be taken with the investments that are to fund luxuries than those that are to fund food.
This is known as liability driven investment. While that term is more often associated with institutional portfolios such as pension funds and insurance liabilities, it applies equally to personal investment. It is possibly not used widely by personal investors. There can be too much emphasis in personal investment in growing the value of the accumulating lump sum. By focusing primarily on the account value from year to year (or worse, day to day), perverse decisions can be made. One example: the rule of thumb that deems the proportion of your investments in bonds should equal your age. That is bad advice.
Alpha is the key to investment yield, as it always has been. Not everyone has the time, interest and knowledge to study and rank investments individually by risk and return characteristics – I understand that. This is where index tracking funds are very helpful. Yet the trouble with the index is that you get both good alpha and bad alpha. Ideally, you want a screen to keep bad alpha out. In an index fund, bad alpha eventually falls out the bottom of the index but it takes you down on the way.
Nominal rates of return do not mean as much as real rates of return. In a low inflationary economy, if you can find assets that will yield 5%pa nominal, you will be on the right track.
This post does not contain investment advice to any individual. It is general in nature, not specific.