Does earning 7.5% req a risky portfolio?

There have been several pieces of information over past weeks discussing the challenge for investors getting acceptable levels of returns with low levels of risk.

In a research brief by Callan, a real assets consulting practice based in the USA, they looked at rates of returns for (US) investors over the decades. Back in the 1990's, an investor could earn 7.5% from a simple portfolio of fixed income investments. Much the same could have been earned in NZ at the time.

But by the mid 2000s, an investor seeking a 7.5% return would have needed a portfolio containing 48% relatively risky, return-seeking assets, with just 52% in fixed income. In the NZ context this would have required domestic and overseas equity investments alongside some commercial property.

And by 2015, an investor had to risk up the portfolio even more and include 88% in return-seeking assets, with just 12% in fixed income.

Figure 1; In the US achieving a 7.5% return has added investment complexity and has increased risk

Meanwhile, the standard deviation (a broad measure of risk) almost tripled from “only” 6% in the 1990's to 17.2% in 2015.

Standard deviation represents a variability of results, which is more or less the broadest definition of investment risk. It is a measure of how far returns can range from the expected annual rate of return. A bigger standard deviation means a greater range of potential outcomes. It represents how much returns could be over or under expected results. The typical statistical reading is that one standard deviation around the expected case captures about 68% of potential results, and two standard deviations about 96%.

To illustrate this point, assume that in 1995 an investor had a 7.5% return expectation with a standard deviation of 6.0%. One standard deviation down would be a +1.5% return and one up would be +13.5%. Two standard deviations would be -4.5% to as high as +19.5%. That is a fairly narrow range.

For a standard deviation of 17.2%, which is what Callan projected for the 2015 portfolio, the risk is much, much higher; two standard deviations would yield a range of -26.9% to +41.9%.

In a local piece, Tony Alexander, an economist from the BNZ, noted why he wouldn't provide investment advice;

“The first (thing to do) is accept that the world has changed since the global financial crisis and investors need to lower their yield expectations. If you don’t then you will chase yield and possibly fail to recognise that means accepting a lot more risk”.

Callan also notes this - to keep risk low requires investors to accept lower rates of return as noted in Figure 2. Although again the data is US based, the same principle will apply in the NZ market.

Figure 2; To keep risks to a reasonable level requires more complexity and for investors to accept lower annual returns

The question posed at the start of this article has been answered, at least for the US and NZ markets. But are there diversified investment opportunities with reasonable risk profiles available to investors?

MyFarm is one of a number of parties who provides New Zealand rural property investments. In the past these have mainly been the ownership and operation of dairy farm businesses. Up until 2015 the 20 year track record of this portfolio was for a return of >18% p.a. which can provide inflation protection, diversification, and growth in an investment portfolio. However, these sorts of investments can be volatile, illiquid, and generally the fees are higher than with other investments.

With MyFarm’s latest series of offers we are addressing operating risk and volatility by contracting with strong counter-parties with long term leases with the objective of providing monthly cash-flow returns (targeting 8% p.a.), we are utilising conservative gearing levels and we are focusing on quality investment targets and industries.

For one of these opportunities, please see our latest Marlborough Sauvignon Blanc Vineyard buy, develop and lease offer.

In conclusion, we believe that there are select rural investments that can assist investors get closer to their target 7.5% return without excessive risk.