In my last article, I looked at aspects of portfolio plann-
ing, including diversification, correlation, projecting investment returns and the measurement and use of volatility.
In this and subsequent articles, I will concentrate on one part of portfolio planning – volatility – looking in turn at investment risk, the difference between average rates of return and volatility and, last, risk and reward.
Average fund performance is only one aspect of investment risk, that is, the risk that long-term returns may fall below expectations. Another is volatility, which involves a much shorter-term var-iation in investment returns.
The concept of investment risk is generally very well understood by the majority of financial advisers and, it appears, almost always highlighted and explained to clients.
However, the principle of investment risk is most usually defined in popularist terms as the chances that, over a period of time, the average rate of return will or will not exceed a specified or projected percentage in order that a particular investment strategy might work in the client's favour.
Hence, for example, an income-drawdown illustration might show that a client's fund needs to achieve an average annual rate of investment return of, say, 8.5 per cent if drawdown is to prove financially profitable over conventional annuity purchase.
A lower average return than 8.5 per cent will, it is simplistically surmised, result in the client being financially disadvantaged while a higher rate than 8.5 per cent will result in financial gain.
In isolation, though, the average rate of return can only reveal half the investment risk picture – volatility is the other half. To illustrate the difference in effect between average rate of investment growth, and volatility, let us start by taking a deliberately exaggerated example.
Fred, aged 60, retires with a personal pension fund of £100,000 after taking tax-free cash. He transfers this fund to an income-drawdown contract and takes the maximum permitted income of, say, £10,000 a year. Unfortunately for Fred, in the first year his investment fund falls by 50 per cent so after taking his £10,000 income withdrawal, he has only £40,000 remaining in his fund after just 12 months In the second year, his investment fund unfortunately falls in value by a further 40 per cent, leaving him with only £14,000 after taking into account his £10,000 withdrawal. In year three, Fred sees his fund fall by a further 20 per cent which, after taking into account his £10,000 withdrawal, leaves him with only a little over £1,000. At this point, his drawdown contract is due its first triennial review.
We will assume that Fred's investment performance then improves somewhat dramatically over the following years although obviously not nearly enough to permit Fred to take anywhere near the level of income he enjoyed for the first three years (or would have enjoyed if he had chosen conventional annuity purchase).
Much later, in the year of his 71st birthday, his investment fund grows in value by a staggering 500 per cent.
However, by this time, Fred has only 2p remaining in his fund (not, I have to stress, a scientifically calculated value) and this therefore grows to the princely sum of 12p during the year although it still does not, of course, permit withdrawal of any meaningful level of income.
In the following year, investment performance once more enjoys staggering growth – this time of 400 per cent. However, when applied to the remaining fund of only 12p, this still only gives him a fund of 60p in total and again no possibility of withdrawal of income. This phenomenal growth continues until he reaches 75 but, because of the low base, his total accumulated fund is a meagre £14.78 with which to buy a conventional annuity.
“Right”, says Fred, “I am going to claim that I have been given bad advice.”
His financial adviser revisits the file, only to discover that the original illustration indicated that an average rate of growth in excess of 8 per cent should have made the drawdown strategy profitable.
Adding up each year's investment gains in percentage terms, deducting losses and then dividing the total by the number of years of the contract, the adviser arrives at an average annual return over the 15-year period of, say, 20 per cent. This high average has arisen as there were some very big investment gains towards the end of the drawdown term which more than counter- balanced the losses during the early years.
Nevertheless, despite the apparently high average investment return, it is indisputable that the drawdown strategy has failed here. Fred has been able to enjoy only an extremely small level of income withdrawal (even without taking charges into account) throughout the last 10 years of the 15-year contract and now retains only a negligible fund with which to buy a conventional annuity.
What has gone wrong? Clearly, the losses in the early years, especially coupled with a high level of withdrawals, made it impossible for gains in the later years to compensate.
Average rates of return give, quite simply, a snapshot summary of the overall fund performance over a given period of time. Volatility, in contrast, shows how bad or good the performance may have been from one period of time to another.
It is a well understood principle of investment that risk and reward almost invariably go hand in hand. The greater the desired reward, the greater the level of risk the investor must accept.
For example, over the longer term, returns on equities have far outstripped returns from Government bonds which, in turn, have far exceeded returns from cash deposits.
Looking to the future, there is little doubt that an investor has a greater chance of losing a significant part of his capital by investing in equities as opposed to investing in gilts (at least over the short term) and a greater chance of a loss in a gilt investment than by putting money on deposit.
A greater potential investment reward from equities is only possible by accepting a greater level of risk although it must again be stressed that this applies particularly in the shorter term.
Equity values are generally more volatile than gilt prices which, in turn, are generally more volatile than returns on deposits. But how can we measure the volatility of investment returns? The only widely accepted measurement of volatility for asset classes, sectors and individual funds is the standard deviation.
To the left is an example of how volatility can work against the client even if the average rate over five years is favourable (especially where regular withdrawals are made out of a falling fund).
In my next article, I will elaborate more on the subject of volatility and, more specifically, standard deviations.