Question:

Hi Mark -

I am in my 70s and happily retired. I support myself from the earnings of my SMSF.

I have broadly divided my fund’s assets into two categories. The first is my core fund (a 7-figure sum) which is to support me for the remainder of my life. The second (a smaller sum) is for investment in equities, ETFs, bonds and the like.

In other words, the former category is to sustain my quality of life while the latter is to enhance it.

As you would know, in all likelihood interest rates will be lowered by the RBA at least twice in the next 6 months. So, when the term deposit for fund 1 matures in August, I can expect that the interest rate I currently enjoy (over 5%) will reduce to less than 4%. This will barely match the diminution in value caused by inflation.

I am accordingly looking for options with a higher rate of return than term deposits, but with less investment risk than equities, bonds and private equity loans.

The safest course would seem to be to purchase shares in safe, boring, blue-chip Aussie companies (the Big Four banks, Macquarie Bank, CSL, Cochlear, BHP and Telstra).

It occurs to me, however, that there might be a middle-ground option that is less risky than relying on my own inexpert judgment purchasing equities and likely to provide a greater return than a term deposit.

That is, investing in ETFs (more than one, to spread the risk) which Morningstar rates as Gold. This enlists the professional expertise of analysts and investors to make and maintain the investment of my fund 1 monies, at a net risk less than relying on my own limited skills, and at a modest cost (especially if I invest in passive ETFs.

I accept that every investment carries a risk of failure. But it seems to me that an investment of my non-risk capital in ETFs is a minimal extra risk compared to a term investment, with a good chance of a significantly higher return than a term deposit.

This is especially so if I make the investment for at least 5 years (which will allow the financial detriment of a bad year to be recovered) and select the ETFs by using the assessments from time to time made by Morningstar.

I would be interested to know what you (and your readers) think of my approach to resolving my pleasant problem, and the conclusion I have reached.

Answer:

This question has a bit of everything. I am going to tackle this from several different angles.

The return you need to achieve your goals

The driver of the potential change to the portfolio is the expectation that interest rates will be lowered which will impact the return on term deposits. The level of interest rates does drive investor behaviour.

It was only a few years ago that investors couldn’t stop talking about TINA – there is no alternative. This acronym referred to the notion that low interest rates left investors with no option but to forgo cash and instead buy shares.

Instead of simply comparing returns from different types of investments I encourage people to have a return target in mind. Having a return target means an investor can add some structure to decision making around asset allocation and the relative trade-offs between different asset classes.

If you know you need a six percent return annually it adds some context to the expected reduction in term deposit rates.

That is the first step I would encourage this member of the Morningstar community to take. Charlie Munger perhaps said it best: “A majority of life’s errors are caused by forgetting what one is really trying to do.” Step one is knowing what you are trying to do.

The difference between an individual share and ETF

One advantage of ETFs is instant diversification. I think many investors are confused about diversification. To me the rationale for diversification is straightforward. It is to avoid catastrophic losses that prevent an investor from achieving their goal.

Catastrophic losses in individual shares occur more frequently than many investors acknowledge. J.P. Morgan did a study on catastrophic losses called The Agony and the Ecstasy.

The focus of the study was the Russell 3000 index, which represents the entire US stock market. The researchers found that 40 percent of all stocks suffered a permanent 70 percent plus decline from their peaks. These companies never traded again at more than a 60 percent loss from their peak.

That scenario can be very challenging for a retiree even if a portfolio is well diversified. The question referenced Blue Chip shares. While a large, mature company is less likely to suffer a catastrophic loss it does still happen.

A well-diversified ETF is a good way of avoiding catastrophic loss. However, a share ETF is very different from cash.

Does volatility matter?

The investment industry equates risk with volatility. For most long-term investors this just doesn’t make sense. Volatility is not the problem for long-term investors – it is earning a high enough return to achieve their goals. Exchanging short-term volatility for higher long-term returns is a trade-off worth making.

However, for some investors volatility is a risk. The risk Is not the volatility but having to sell when the market is down. And investors that need cash have no choice but to sell no matter what is happening with the market.

The member of the Morningstar community that submitted this question is retired and 70 years old. I don’t have a full picture of his financial position but introducing more volatility into his portfolio could be a problem if he doesn’t have other cash reserves.

It is clear that he understands this and made a point to say that he wouldn’t have to sell for at least five years. This is reassuring. Most of the time this is an adequate amount of time for markets to recover.

However, there have been outlier events in history where five years wasn’t adequate. It took more than seven years to recover from the 1929 crash. The .com crash took a little less than 13 years for recovery. The crash in the early 1970s took 11 years to recover. There were five crashes in total since 1900 that took more than five years for a full recovery.

None of this is to say this strategy won’t work. Investing is a risk-taking endeavour. Hopefully this answer helped to provide more of a picture of the risk of different options.

What do you think about the approach being taken by this member of the Morningstar community? Write me at [email protected] to share your views.

Get more Morningstar insights in your inbox