5 truths to investment returns

How often have you looked at your investments and been disappointed with a reported annual return? Often we view this return as a percentage amount of growth or decline based on the value of the investment from the previous point in time its value was measured.

Understanding the detail here will help you avoid making poor choices on whether to buy, sell or hold an investment. It may even help remove angst and benefit your wealth by understanding things in better detail than most others around you or what you hear on TV.

Here are the 5 core Truths of returns.

1. What time period is actually relevant to me?

2. Are all my costs and sources of gain being quoted?

3. A good or bad return? Compared to what!

4. The volatility of returns experienced

5. The impact of ‘Time’

The competitive industry of investments means quoting one and even 3 year returns are king, even if it’s not well suited to the type of investment you are in, or for the time period you will likely need it for. For example the last year’s return from a shareholding or super fund is of little importance if you are under 70. This is because your time frame of holding the investment will need to look at 15 years and longer.

As you would imagine a lot of research has been done on this. In managed/super funds for instance there is an 80%+ likelihood that those funds this year in the top quartile of all fund returns won’t be there in 3 years’ time.

People are drilled into viewing investments always going up in value is the only good investment to own. They make good TV headlines and help the investment’s promoters. Volatile investments are seen as bad, but often they fail to record the amount of cash these investment distributes each year and adding this back in. the same for their longer term returns. Growth investments need more time. You don’t have to ‘time’ your entry and exit to gain a healthy return if you use the passage of time to let things play out.

On the cost side fees and inflation are just as crucial. Even more so when interest rates are at such low levels which impact nearly all investment types in one form or another.

So far this means to also only look at time periods that you are likely to hold the investment for to suit the use you have in mind for it. Beware 1 year returns. They aren’t a good indicator to help a decision for true investors. Most investments will have 10 years of history so try this measure first and update the latest 10 year return every year (or longest one you can find). Next look at this return assuming all income had been reinvested (even if you spent it) and deduct fees and inflation.

In total look at the NET REAL ROLLING RETURN for “x’ years. X being the time period closest to how long you require the investment to stay in place for.

Have you heard someone say I earned a great return on my <insert share, property, gold etc>.

A wise response would be, “Compared to what?” If you earned 8% p.a. say for 2 years but inflation ran at 3%, costs another 2% and tax subtracted say another 0.5% is the resulting 2.5% still good? What if all similar investments earned 10%? Most of all can they keep repeating similar results for the time period they need it?

There are also distortions in place between certain types of investments. Generally ‘financial assets’ such as bonds and share are transparent in factoring in all costs, whereas residential property rarely is. The costs of all those Bunnings trips, labour, repairs and other such costs (and especially inflation) are rarely accounted for in the headline stories of real property.

Likewise higher returns don’t mean better returns (for you personally) if the degree and number of risks taken to achieve them are also higher (which is nearly always the case by the way). This is especially true if your goals mean you only require a return of say a gross 6% each year, yet the risk you’re exposing yourself to trying to gain more than what you need could work against you terribly!

Add to our list then is FORGET the JONES and FACTOR in all COSTS and INCOME too!

Know leverage’s impact. Whilst on the topic of property many investors don’t actually understand where their returns are coming from. Most property investors have borrowed funds to do so. This is called gearing. It is the leverage or gearing that’s producing the real performance here. We can explore this in another update.

Investments that constantly move up, down and up and down….. are viewed as risky. This summation can be detrimental to your monetary prosperity. Take two investors regularly investing a fixed sum of money each month. Assume they also pay the same income every year too. They both produce the same overall return over say a 5 year period. One had a nice smooth annual return and the other had a very bumpy ride. Both ended up with the same average return. Comparing the end result its highly probable the person invested in the volatile investment has a greater pile of money, and producing more income too. How can that be? Google ‘Dollar Cost Averaging’, then click on the ‘images’ tab. It’s explained really well with examples and mathematics to prove it.

What can you take from this? Embrace volatility......If you are investing regular fixed dollar amounts at a set time every month or quarter (Your super is a great example), then embrace volatility in the criteria you set for selecting an investment. Have a lump sum to invest? Then it also works to reduce risk by dividing it into 12 equal lumps and investing on the same date each month until it’s all invested. Your return will actually be a number higher than the published latest return advertised in all probability! That’s how the maths work.

Excessive volatility can be bad for retirees if you are forced to cash-in parts of these types of investments to create enough income. There are simple no-cost strategies to help protect you from this whilst still having exposure to essential growth investments.

Last but of most importance is the impact of time. Nearly everyone, including those managing investments on your behalf don’t take enough ‘time’ to understand the impact of ‘time’ on money and its returns. Already we have spoken about time on matching the right period to the length of time you require the investment.

Actual dates used to measure performance is important. Using probably the best period of all to illustrate the point is the 1987 October stock market “crash” on Black Monday the 9th. The problem is for the year of 1987 there was no crash at all. In fact markets actually rose over the year between 6 and 9% in most western countries.

Crash? What crash? If you measured a year as being January 1st to December 31st that is. The market in a month fell by over 40% and that grabbed the headline. The crash was because in a period of less than a year the share markets went nuts rising way too steep. If you invested right after the plunge, a year later you would have made over 25%!

Dates matter. Imagine the difference of a one year return from 30 September 1987 to September 1988, versus October 30 1987 to October 1988. One investor would be very glum, the other elated! How many invested in the next 2 years after October 1987 was very few indeed. A Pity.

What was also lost in the headlines is that most companies continued to operate and earn profits and distribute income, but none of that was figured into people’s calculations. Another pity, but a good lesson to remember.

The rule here is a single month’s difference in reporting dates can and do make a big difference especially when measuring returns under 10 years. If comparing two investments always choose the exact same measuring dates.

Time can work to your advantage as well but you will likely have to override the natural instinct to buy when others sell and visa versa. Time here is your friend. Time to ride out volatility as we have also examined works in your favour. Focus on something else when things get volatile- don’t fiddle with your investments, stop listening to negative commentary at these moments!

The worst impact of time is to be a forced seller of an investment and you haven’t utilised (or can’t) Dollar Cost Averaging and slowly sell down. This most often happens when we haven’t protected income sources or have to access lumps of cash in a hurry. If you have geared your investment the result is like a ‘double down’ bet in the negative. Again getting your time frames matched of what you have invested in with when you will need access to its capital is crucial here.

Time also defines the difference between speculators (who often label themselves as investors), and investors. Buying and selling frequently of anything is speculative and you have to get successive groups of 5 decisions correct consistently for years. Lots of risk here and laws of probability are against you make no mistake.

The good news for most of us we simply don’t need to take on these risks to get where we need to be. So the next time you are assessing the performance of an investment be careful not to act in haste before considering these things and the likelihood is you will make better decisions that helps build your wealth.