What to look for when comparing super funds’ investment returns
When deciding how to invest your money, a good strategy is to consider how much return you need, and how much risk you can afford to take. In this commentary:
- Beware of a headline-grabbing rate of return
- Understand why risk matters and how it relates to returns
- Learn about comparing investment options with risk-adjusted returns
When it comes to your investments, are you comparing apples with oranges?
Most people focus on returns when they think about their investments. And why wouldn't you, when you've invested to grow your money. But be careful...focusing solely on average returns can be misleading when comparing investments.
If you’re not also looking at the underlying mix of assets in a portfolio and how much risk was taken to achieve the return, you could find yourself comparing apples with oranges, and that’s potentially dangerous.
Why does risk matter and how does it relate to returns?
All else being equal, the more risk that’s required to earn a return, the less that return is worth.
Investors with a higher tolerance for risk demand a higher return as compensation for more variation in the range of returns. An investment expected to achieve 10% growth, could also potentially deliver growth of 20% or a loss of 10% instead.
In this type of investment, if you need to access your money in the shorter term, you might be forced to sell assets when markets have fallen. This means you would be locking in losses, which can be damaging. This is why it’s prudent to only take as much risk as you need.
The appropriate asset mix for you will depend on how soon you think you’ll need the money.
Generally speaking, younger investors can probably have a higher risk portfolio than those approaching retirement. So that means, a portfolio designed for younger investors can generate a higher, long-run return, but has a greater chance of losing money over the short run.
Let’s look at an example
Consider an investment option that invests in only shares.
Over the long run, you can expect to earn 8% or 9% a year, but it comes with risk. If you’d invested just before the Global Financial Crisis of 2008, your share portfolio could have lost around half its value in a year.
If you’d needed to access your money at that time, you would have been forced to sell at a big loss.
Most people prefer a diversified portfolio, which has an allocation to growth assets like shares, as well as defensive assets like cash and fixed interest.
While this diversification reduces the risk, it also reduces the long-term return, so you need to know how to make the right trade-off.
So how do you find the right balance of risk and return?
Simply comparing the average returns of two investment options might tempt you to just switch to the one with the higher return.
That’s when comparing apples and oranges can be dangerous. Past performance is not a good guide to future performance, and choosing your investment option based on past returns, is like driving by looking in the rear-view mirror.
A better way is to consider how much return you need, and how much risk you can afford to take.
This is unique to you, and a financial planner can help you find an investment option that fits the bill … one that meets your return objectives, but isn’t going to be so risky, as to leave you in a difficult position.
Feel confident about your investment decisions
So, the next time you’re at a barbeque and hear someone talking about their great investment returns, ask yourself: “How risky was that investment?” “How much might they have lost had things turned out differently?” and “Is that a risk they’d have been comfortable taking”?
After all, people rarely talk about investments that went the other way…
Your financial planner can help you understand how much risk you’re taking and can help you compare investment options based on risk-adjusted returns.