The power of compounding
March 2016
Why a low-volatility approach is so important
Key points
- In retirement investors still need to take some investment risk. Otherwise, returns over the medium and longer term are unlikely to keep up with inflation.
- When investing for people in retirement, it makes sense to adopt a lower-risk approach to investing in shares.
- By reducing the impact of down-markets, investors are much more likely to achieve a better outcome over the medium and longer term. This effect demonstrates the benefit of compounding returns.
When you retire, you’re likely to have many years of retirement ahead of you. So it’s vital that your savings continue to grow in retirement. At StatePlus, we use a combination of shares and other types of assets in the ‘growth’ assets part of portfolios. The reason for this is to provide good returns above inflation over the medium and longer term.
But one characteristic of shares is their volatility, and the possibility that negative markets (drawdowns) can occur. For this reason, we target exposures to shares that are less volatile than the average.
By using this approach, we expect the investment outcomes to be smoother over time and this should reduce the impact of negative markets. What this means is, if you don’t lose as much during a down-market, your portfolio will have less to make up when markets recover. This highly-beneficial effect is known as compounding.
To find out more about the power of compounding and how it could benefit you, please speak to your financial planner.
Download PDF: Compounding - Why a low-volatility approach is so important
The examples below show how compounding works.
The power of compounding
Example 1 – Performance in rising and falling markets
The chart below shows actual summarised data for one of our investment managers. This manager follows a low-volatility approach. The chart shows the actual monthly downmarkets and up-markets of the international share market over the last 10 years. It compares how the market and the portfolio have performed on average in each of the rising and falling markets.
Key points
- In down-markets, the portfolio tends to fall less than the market, that is, it outperforms the market (a).
- In rising markets, the portfolio will often lag the market slightly because of its more conservative approach (b).
- Importantly the extent of the outperformance in falling markets (a) is greater than the underperformance in up-markets (b). This effect has a powerful impact over time, leading to better compounding returns.
How managing volatility can lead to better returns
Example 2 – Cumulative compounded return
This example uses the same data from Example 1 and compares the cumulative investment return (i.e. the return over the whole period) of the same investment manager’s portfolio with the overall market over the same period. It shows that over time, this portfolio reduced volatility by over 30% and improved compounded return by more than 30%.
Key points
- When markets are falling, the portfolio has performed better than the market average, even though both are negative.
- Over time the portfolio achieves superior growth.
- Over the 10 years (of actual data), this investment manager has reduced monthly risk, or volatility, by over 30%.
- It has improved the actual compounded return by over 30%.
- This clearly shows why using a low-volatility approach for managing shares should deliver an overall better outcome for your portfolio.
A smoother ride over time
Example 3 – The value of Henry’s $100,000 over time
Henry is a retiree who started with a sum of $100,000. He draws a constant 6% each year on a monthly basis, which works out at $6,000 in the first year. If Henry’s assets had been invested with the same investment manager as shown above, he would have received a much better financial outcome with around $27,000 more at the end of the 10-year period than if he had been invested in the broader market.The chart below shows that with a more stable investment, over time Henry benefits significantly from the reduced impact of drawing income during down markets. How is this so?
Henry’s portfolio delivers a smoother return overall which benefits from a better compounding return over time. And over the medium and longer term, this results in a better financial outcome.
