Riding out the super fund slump

The slump in investment markets has seen super funds post negative returns for a second financial year. While very disconcerting, periodic negative returns from growth assets are normal and are the price we have to pay for the higher long-term returns they provide. Reacting to the current turmoil by moving to cash will lock in losses and only lead to lower long-term returns.

Fortunately, there are signs of improvement. Share and credit markets led the way down and they are now leading on the way up, as the global financial crisis is abating and leading economic indicators are pointing to an economic recovery ahead.

The key driver of returns for an investment portfolio is the asset classes in which it’s invested. The most common diversified superannuation funds have 70% of their funds invested in growth assets (mostly shares and property).

The logic is that over the long-term, growth assets provide higher returns. Of course this is not necessarily so in the short-term and unfortunately over the last year most assets, except cash and government bonds, have had significant negative returns. Even unlisted assets such as directly held commercial property, infrastructure and private equity have come under pressure. As a result super funds have had a second financial year of losses.

After such a bad run the temptation is to think that cash is a better bet. However, there are several points to note.

Despite volatility, shares have higher long-term returns

The first thing to note is that while shares provide a far more volatile ride than say cash or bonds they provide much higher returns over the long-term. This is evident in the next chart which compares the cumulative pre tax return from $100 invested in 1928 into each of Australian cash, government bonds and equities. The chart starts in 1928 as I don’t have monthly returns for cash before then. Note that it’s also a log scale otherwise the lines go exponentially up pretty quickly and look silly.

Over the whole period cash provides a relatively steady ride but only returns an average 5.4% pa such that $100 invested in 1928 would have grown to $6,879 today. Australian Government bonds are a bit more volatile and provide a slightly higher average return of 7% pa taking the $100 to $23,331 today. By contrast Australian shares provide a rougher ride, but the benefit is that thanks to an average return of 11.5% pa, the $100 invested in 1928 would have grown to $668,625 today.

The point is that with shares we have to take the bad (periodic negative returns) with the good (higher long-term average returns). Over the last century shares have had numerous setbacks (1930s crash, the near 60% plunge in the 1970s, the 1987 crash, etc), but the market has always recovered to resume its rising trend.

Periodic negative returns in super funds are not nice but are normal

Secondly, periodic negative returns from a diversified mix of assets are normal. Traditional diversified investment portfolios that underpin most superannuation funds aim to reduce the volatility associated with shares and other growth assets by having some exposure to cash and bonds.

But despite this the historical record indicates that traditional diversified portfolios (cash, bonds, property and equities) have negative returns every six years or so.