After seeing their super fund balances ‘going backwards’ at an unprecedented rate, members invested in the typical default growth options could be forgiven for thinking that super was a poor investment. Yet the reality is that, measured over an appropriate period, returns have been pretty much in line with what they should have expected. The problem is that most people’s expectations had become too optimistic.

2008 was the famine after four years of feast. The average growth fund with 70% of its investments in growth assets (mainly shares) lost 22.2% over the year (before fees and tax). Over the previous four years, it had grown by 66.5%. When we look back over the full five years, the average return was 5.3% pa. That compares with an average increase in the inflation rate, as measured by the CPI, of 3.1% pa.

The typical return target for these funds is to outpace inflation by 4% (before fees and tax) over rolling periods of five years, so on that score they failed to meet their target (2.2% achieved versus 4% targeted). In terms of risk, the typical expectation is for a negative return to occur once in every six years, on average. Looking back over the past 30 years there have been four negative years. So again, the experience has been broadly in line with expectations.

But the shock of 2008 was so severe that it’s hard for members to take such a rational, long-term view. They experience risk as an emotion, a feeling, not as a formula. So, having experienced the feeling, now is an ideal time for them to really question their attitude to risk and to think about whether their current investment option really matches their risk tolerance. In doing so, it may help if they understand just how unusual the 2008 experience was.

Table 1 draws on historical data from January 1980 to December 2008. It shows the four calendar years in which growth options (70% growth assets, 30% defensive) experienced a negative return, together with the performance that immediately preceded and followed those negative years. Interestingly, calendar 1987 recorded a positive return of 4.2%.

One obvious point to note is the sheer magnitude of the loss in 2008. At -22.2%, this was more than three times worse than the losses in 1990, 1994 and 2002. This perhaps highlights a flaw in risk profiling questionnaires. They generally ask for a response to the possibility of a one-year loss, but someone who is comfortable about losing 5 or 6% in a year may be far less comfortable with the prospect of a 22% loss. In fact, they might not even contemplate that as a possibility, since they have had no prior experience of such an event.

We might ask, therefore: “What is the likelihood of a growth option losing 22.2% in a calendar year?”

The answer, based on conventional expectations, is something like 1 in 60 to 100. So what we have experienced is something approaching a ‘once in 100 years’ event.

Another observation from the table is that the years of negative return have been reasonably spaced out, with gaps between them of 4, 8 and 6 years. This pattern conforms broadly to the theoretical risk of a negative return, which for growth funds is approximately 1 in 6. Note that this does not mean we expect negative years to come along at intervals of precisely six years. Rather, it means that the risk of a negative return in any single year is 1 in 6.

Looking again at Table 1, we can see that negative returns generally follow extended periods of quite strong performance. It seems that markets ‘get ahead of themselves’ and need a correction to pull them back towards their long-term trends. Most times the correction is relatively benign but, as we have seen, 2008 was a notable exception.

In ‘normal’ times, the years following a negative return have generally produced strongly positive returns. Again this is shown in the table. So there is some hope for those unhappy members in growth options that their fortunes will turn around reasonably quickly.

Roughly speaking, 2008 completely wiped out their gains from 2007 (+6.2%) and 2006 (+15.9%). To get back to where they were at end-December 2007 (ignoring new contributions) requires a positive cumulative return of 28.5%. If we look at the three previous negative return years in our data series, on each occasion a return of about that much was achieved within two years. Whether that will happen again this time, given the severe damage being felt in financial markets and reflected in real economies, remains to be seen.

For investors looking for a turnaround, the early weeks of 2009 have provided no encouragement at all. The gloomy outlook for global economies raises the possibility that we may be facing another calendar year of negative returns. We consider that unlikely, given that markets tend to anticipate events rather than be led by them, and may well rebound later this year. However, the 2008/09 financial year will almost certainly be negative, as was 2007/08.

In theory there is no reason why negative returns could not occur in consecutive years, but in practice they tend not to. That is because these are not random events, but rather they are driven by economic and market cycles. If back-to-back negative returns were to happen it would be highly unusual. Statistically, based on the experience of the past 30 years, there is only a 1 in 25 chance of consecutive years of negative performance.

The main argument for investing in a diversified fund is that exposure to different asset sectors helps to cushion the overall portfolio in the event that one or more sectors perform especially poorly.

If we look now at single sector share options as opposed to diversified options over the same time period, we see that the frequency and magnitude of negative returns increases. This is what we would expect, since we have removed the beneficial smoothing effects of diversification. The following tables are for options that invest purely in Australian shares (Table 2) or unhedged international shares (Table 3).

To a statistician, volatility and risk are virtually synonymous. They both describe the likelihood of a result that varies from the average – either up or down. But to the average investor, risk is all about loss. They are really only concerned about returns that are low or negative, while upside volatility – meaning returns higher than expected – is more likely a source of joy.

We have canvassed some of Australia’s leading asset consultants to produce Table 4, which shows the expected risk and return characteristics of diversified options ranging from Conservative to High Growth. Note that these are long-term returns (10 years +) and assume a ‘normal’ investment climate.

The one column in the table that may puzzle some investors is the expected standard deviation. Put simply, this is a measure of how confident we can be that the actual return in any year will fall within a certain range either side of the expected return.Let’s see what this means in a ‘normal’ distribution. Graphically, a ‘normal’ distribution looks like this.

To put it into words:

• 68% of the time we expect the actual return to be within 1 standard deviation of the expected return;
• 95% of the time we expect the actual return to be within 2 standard deviations of the expected return; and
• 99.7% of the time we expect the actual return to be within 3 standard deviations of the expected return.

So, for a growth option, 68% of the time we expect the actual return in a year to fall in the range of 0 to 16%. That is, the expected return of 8%, +/- the expected standard deviation of 8%. 95% of the time we expect the actual return to be between -8% and 24%, and 99.7% of the time we expect it to fall between -16% and 32%.

For a fund member concerned about low or negative returns, it’s the left-hand half of the graph that’s of most interest. Statistics treat low or high returns as equally risky, but investors don’t, so the areas to the left of the standard deviation markers are where they will naturally focus.

We have said that 68% of the time we expect a growth option to return between 0 and 16%. Thus 32% of the time we expect the return to fall outside that range, and half of that (16% of the time) it will fall outside at the low end – ie a negative return.

We noted earlier that members may tolerate an occasional year when the return is mildly negative, but when it gets seriously negative they may be more uncomfortable. If we take anything worse than -8% as ‘seriously negative’, that means more than two standard deviations below the average. The chances of a return that far away from expectations are 5%, but only half of that is on the negative, left-hand side of the graph. So only 2½% of the time do we expect a return worse than -8%, which equates to a 1 in 40 chance.

This analysis assumes that returns follow what statisticians call a ‘normal’ distribution pattern. There is a growing body of research that suggests that the ‘normal’ pattern does not apply to share market returns, and that the risk of large negative or positive returns is greater than previously thought. The heightened volatility of recent years would tend to support that view and this is reflected in our calculations.

Given what investors have just experienced, and their desire for knowledge as a result, trustees and advisers would do well to develop examples along these lines for their own funds. By expressing outcomes in ways that members can understand they can help those members to acquire a better feel for what to expect from different investment options.

Some members may prefer to construct their own investment mix using single sector options, so in Table 5 we have set out the expected returns and standard deviations for the main asset sectors. Again, these have been distilled from our discussions with asset consultants.

Now that fund members have experienced investment risk the hard way, it is opportune for them to reassess their risk tolerance and satisfy themselves that they have chosen the right investment option. That is particularly true of older members, who may not have the luxury of time to replenish their retirement savings.

We know that asset allocation is the key to investment performance, so what is the right asset allocation or investment option?

Jack Bogle, a well-respected and highly experienced investor who founded Vanguard Group in 1974, has a rule of thumb that an investor should take their age and have that percentage of their assets invested in bonds. Adapting that idea to the Australian superannuation scene, a 30 year old should be suited to a 70:30 growth option, a 50 year old should be thinking more in terms of a 50:50 balanced option, while a 70 year old pension member would be looking at a 30:70 conservative option.

Of course a rule of thumb is just that. There are young investors who are innately conservative, just as there are older investors who are natural risk-takers. And of course there are personal investment goals and non-super investments to be taken into account. There is no ‘right’ option for any age group. It is only by understanding the risk/return trade-off of different asset sectors and different investment options that fund members can know what to expect and what is likely to suit them best.

Any change of investment strategy needs to be considered carefully. For example, someone moving now out of a share-based option into a more conservative option risks missing out on the eventual rebound in equities, and moving into what may be a deteriorating bond market. Should they wait until they have recouped some of their losses, or is there a risk that things could get worse still? These are decisions to be made with the help of good professional advice.

Knowing the likely range of outcomes is one thing, but experiencing them is another. It is only by going through the experience that members can tell what feels right for them. Meeting your investment objectives is important, but not as important as sleeping well at night.

This article is about investment risk as it applies to super and pension fund members. It has been written at a time when negative returns have been widely publicised and some critics have questioned the wisdom of investing in super at all.

Sadly, some people fail to make the distinction between a paper loss in a super fund and a realised loss in some other investment. The papers are currently full of stories of investors – many of them middle-aged or older – who have borrowed, invested in falling markets and lost not just their capital but also their homes or other assets. These people have had their financial security ruined, either as a result of greed or poor advice.

It is vital that super fund members recognise the difference. Trustees know that their funds are not allowed to borrow directly, but do their members? And do members know that their fund does not invest in highly speculative property projects or similar high-risk ventures? If not, they should be told. Otherwise they may just assume the worst.