Be realistic in your investment expectations

ast week I wrote about “reasonable expectations” – the very rough and vague benchmark often used when considering whether you have received value for money from the financial services industry.

It is something that is easy to prove for, say, a life assurance risk policy, where you are told in advance that when you die a benefit of R1 million will be paid out. That is your easily certifiable reasonable expectation of a benefit for your dependants.

When it comes to investments, it is difficult to prove or disprove post facto that your “reasonable expectations” have been met.

In simple terms, “reasonable expectations” on investments apply to the returns you can expect, not the returns you will receive. This is apart from any genuine guarantee of a particular outcome.

According to academic Robert Wasburn, in a paper published in the Washington University Journal of Urban and Contemporary Law, the concept of “reasonable investment-backed expectations” as a factor to analyse an outcome first saw judicial daylight in 1978 in the court case Penn Central Transportation Company versus New York City.

Wasburn says that, since that opinion, (American) courts have “varied in their interpretation of the reasonable investmentbacked expectations doctrine, resulting in a lack of clear direction as to its meaning and importance. Legal commentators have also differed greatly on the meaning and usefulness of this doctrine.”

As far as I know, there is no

Llegally accepted definition of “reasonable expectations” in South African law, although the concept is often referred to in determinations made by the various financial services complaints adjudicators and in court disputes.

The article by Wasburn makes it clear that no court of law is going to simply accept that, because you have been told you may expect a certain outcome from a financial services company, this becomes your “reasonable expectation”.

A case in point has been the absolutely atrocious benefit illustrations that the life assurance industry used to hoodwink generations of policyholders, sending out armies of product floggers to sell what all too often have proved to be investment lemons.

The main selling point was the nominal return you could expect 20, 30 or 40 years hence. The life companies all too often failed to deliver, despite the fact that they had set the expectation, arguing that the illustrations were just that – not a promise in any form.

Incidentally, the life companies made doubly sure you could not complain about your reasonable expectations not being met by preventing the industry complaints adjudicator from considering any complaints about investment performance.

However, to be fair, one of the main reasons people lose money is because their expectations are very often anything but reasonable. Take, for example, people who invest in propositions that offer excessive returns.

Today, we publish a determination by financial advice ombud Noluntu Bam in which a property syndication company offered an investor a 40-percent-ayear return (see “Propspec directors held liable for pensioner’s plight”, below.)

A realistic investor would and should never have this as a “reasonable expectation”, and anyone attempting to sell an investment would or should know that it is very unlikely that such an expectation could be met, on average, year after year.

Last week, I said that a conservative reasonable expectation of a return should be three percent a year after inflation.

But even this could be too high – for example, if you put your money in a bank deposit earning three or four percent, you would be losing money in real terms year after year if the inflation rate averaged five percent a year.

A reasonable expectation is going to be dictated by three main factors: risk, time in the market, and costs:

Risk. The “reasonable” risk you are prepared to take is the most important factor. This means looking at the historical returns of the different asset classes – mainly cash, bonds, property and shares – and the risk of each (see “Risk profiles of the four asset classes”, left).

The risk is simply the volatility of the asset class – namely, its propensity to go up and down in value, with different asset classes having different levels of volatility risk. Shares (equities) listed on a stock market have the record of providing the best medium- to long-term returns, but historically they are the most volatile.

You only need to see how the FTSE/JSE All Share Index (Alsi) has been bouncing around this year to realise how volatile the share market is, to say nothing about the slump of 2008. So the more you invest in shares, whether directly or through collective investment schemes, the higher the return you can reasonably expect, but at the greater risk that when you want or need your money the markets may be in a slump.

Time in the market. There are two big advantages in investing for the medium to long term (that is, for five years or more):

You receive the advantages of compounding returns – your returns themselves earn returns.

Volatility risk tends to decrease over the longer term. So while the equity market may bounce up and down in the short term, as the shares on the JSE have been doing, the general trend is upward. Unless there is a dramatic collapse – such as in 2008, when the Alsi dropped to about 17000 – over nearly every rolling five- year period, you would still be better off now with the Alsi bouncing around between 38000 and 42000.

Over time, volatility risk is like a funnel, with the narrowing of the funnel being equal to time in the market.

Costs. Every additional one percent a year in costs over about 40 years is going to remove about 20 percent of your potential returns. So if you invest in a highcost product, such as most life assurance retirement annuity products, your reasonable expectations are going to take a knock – often a serious knock.

Given that you are investing for the longer term when you make your investment selection, the two most important things to consider in deciding on your reasonable expectations of a real return are the effect costs will have on your investment and the asset class risk. The more you have in interest-earning investments, the lower your risk, but the lower your returns and therefore your expectations. The more you have invested in shares, however, the higher your legitimate reasonable expectations may be, but you must accept that you need to have a long-term outlook to reduce the volatility risk.

DIVERSIFY, DIVERSIFY

The other very important factor you need to take into account to reduce risk is to spread your investments across asset classes and sub- classes. The reason is that if there is, say, a 2008-type collapse in share markets, bond markets are likely to hold up, reducing the impact on your investment.

A portfolio balanced across asset classes, such as a unit trust multi-asset fund, may not provide the same potential returns as a pure equity fund, but it will do so at lower risk.

It is important that you set your expectations at the start of an investment, working out then whether they are reasonable or not, taking account of the underlying investments.

So when you go for advice, get your adviser to explain exactly what your reasonable expectations can be from a product, and why, and get it in writing. If those reasonable expectations are then not met and you have, say, not been told about the high costs of a product, you could well have reason to complain loudly.