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Important investment principles

From an investment perspective:

1. When the sharemarket goes down, investors should not panic and automatically sell their shares (and shift to cash or bonds). All that has occurred is what was expected to happen sooner or later. The sharemarket is expected to go down at times.

2. As an investor gets within 10 to 12 years of when they will spend the money, they should be thinking about shifting from shares to bonds (and ultimately to cash). Note, this should be as they get close to when they will spend their money, as opposed to when they will retire. Normally, when people retire, they do not spend all of their retirement savings at once.

3. When investors shift money from shares, or into shares, they should probably do it slowly overtime and not all at once. This is unless they think that the sharemarket has become too high or too low.

Share returns are volatile

When I invest in shares, sooner or later I will have a year when I get a negative return. History tells me to expect this as the sharemarkets have gone down often. There is no reason for me to think I would be smart enough to pull my money out, just before a “down” happens, and then put my money back into shares at the bottom of the cycle. Also, history suggests that the years when returns are negative are random. They have occurred when the economy is growing and growing above average, and when it is not growing. Most of the negative returns are in the -10% to 0% range, but a few are below this. The pattern of returns of New Zealand shares are “typical” of shares generally.

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Because of this short-term uncertainty, it does not make sense to buy shares for their return over a single year. It is better to buy them for their average return over time. It is therefore important to understand not only the likely average return, but the variation of returns, around the average from one year to the next.

Dividend returns are less volatile

The return shares deliver, is made up of dividend income and the change in value of the shares. The dividend income has typically ranged around 5% a year after-tax (see chart 2). By investing in shares therefore, I can expect a positive return each year from dividends and a generally rising but a volatile capital value. Chart 3 plots the average annual change in value of shares for each 20 year period in the last 30 years.

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The graph above shows for each 20 year period ended on 31 December of the year shown, the growth of an investment made at the start of that 20 year period.

As a rule, I only need to be concerned about the capital value of shares if I need to sell the shares in the near term. But even over a 20 year period, I will not always have a positive capital return. If I had invested just before the 1987 sharemarket crash, I would have suffered an immediate 50% loss and 20 years later, I would have recovered part of the loss but not all. The average return over the subsequent 20 years was -1% a year. I did however throughout the period receive dividends of 4.8% a year, which more than offset the -1% a year. This highlights that if I cannot wait for the markets to return to being positive, I should probably not invest in shares, unless I am willing to accept that I may get back less than I had invested. Also, it highlights that I should not invest in shares in one lump sum on one particular day. If I spread my investment over a longer period, I limit the impact of investing at a market “high”.

Generally shares should be bought, not because you think they will go up in the next 12 months but, because they are appropriate for helping you achieve your financial goals (and you want to own them) whether they go up or down.

The legal stuff

The above article is a general investment commentary. It should not be considered as being personalised financial advice. Members should obtain appropriate financial advice from a suitably experienced Authorised Financial Adviser, before making any investment decisions. Only an Authorised Financial Adviser can legally take into account the person’s personal circumstances. SuperLife does not give personalised financial advice.