Financial Planning – it’s a mug’s game

How long is long term? Is before the US Civil War considered long term?

Click the photo so see a website about the world of the Civil War soldier.

Financial planners are adept at illustrating the appropriate strategy for moving ahead in an ever changing world. At least, this is the conventional theory. The current financial world is anything but conventional, and financial planners are trying to navigate a very peculiar financial world right now.

Financial Planning – it’s not “normal”

In the ‘standard’ financial world, money follows rather logical trajectories. If you borrow money for an investment purpose then you borrow at a rate that you believe you can better through your strategies and efforts. This is a fundamental concept underpinning the money markets. It underpins all analysis of financial businesses. If you think about it, there is a lot of sense in the idea. If you borrow for investment purposes then it would be crazy to use that money for anything other than a purpose that is likely to provide you with a return over and above the cost of funds. In a perfect world, you would like to build in a profit margin and a risk margin as well. That is, if you borrow at 8% then you’d ideally like to earn a return that allows you to pay the interest cost, plus repay your capital at the end of the term, and still have a profit big enough to pay for tax and justify the risks that you have taken.

Sounds simple, doesn’t it?

This logic underpins the idea of a “risk premium”. In other words, the idea that you will receive an additional return for taking on additional risk. However, this thinking is fundamentally flawed. What it should most likely say is that “higher risk brings about the potential for higher return”. There is no direct correlation relationship between the two measures – there is the potential for a direct relationship.

Here is a piece of news – pretty much 99% of every financial planning recommendation is based on the idea that you will receive an “equity premium” for being invested in equities, over that return which is expected to be received if you were to be invested into “debt”. That is, if you buy shares in National Australia Bank then it is reasonable to expect that you would earn more from the shares than you would by investing in the debt issued by National Australia Bank. This is the fundamental reason why so-called “growth” funds predominantly invest into shares and property. This is a relationship that is expected to be fulfilled in the majority of long term measurement periods. Simply put – these are the areas expected to deliver superior returns over the long term.

And this is where we come to the crux of the matter – how long is long term?

How Long is “Long Term Investment?”

Financial planners often talk about “investing for the long term”. Regular readers of this blog will realise that it is a term used quite a lot by financial planners. Even a cursory look through current mainstream financial material will highlight that “long term” today can even be described in terms of weeks or even days. It’s hard not to chuckle when you read that “investors decided not to hold their investments over the weekend, resulting in a sell-off on Friday afternoon” and the like. When reading analyst reports on businesses, “long term” is often used to describe anything more than two reporting periods away. While it is true that all timeframes are relative, one year is unlikely to be a time frame that the average person would put under the catergory of “long term”.

Yet the actual timeframe for an investment is arguably one of the most important issues you could focus on. This is especially the case when considering a portfolio of investments, yet the appropriate time frame is very rarely stated. What does “long term” mean? In most product disclosure documents (“PDS” is the terminology of the financial markets), long term means more than 5 or 7 years. Look through the bulk of prospectii (is that a word?) for superannuation and managed funds and you will find that this is what is usually considered “long term”. However, when the phrase “long term” is used by financial planners, it more often refers to a period that includes two full business cycles. That is, enough time for any purchase at the “high point” of one business cycle to be greater than the “low point” of any subsequent business cycle.

That sounds reasonable enough.

Yet it becomes a little bit messed up when we think in terms of the Australian economy. You see, our business cycle is anything but normal, when compared with the rest of the developed world. We are currently at the tail end of a 19 year business cycle. This is something pretty much unprecedented in developed world economies. In other words, we look better than pretty much every other developed world country at this point in time. This would suggest that our time frames are a bit messed up, when considered in long term, “average” frames of thought. It also can be taken to mean that any measurements at this point in the cycle must be taken with a grain of salt – or that a large amount of cynicism should be attached to any definitive statements about returns in the more recent past reflecting returns in the future.

Would 150 years be “long term”?

The American Civil War was fought between 1861 and 1865. Some would argue that it is still being fought today (just look at the popularity of the Confederate flag as an enduring symbol). The facts tell us that the American Civil War was fought 146 years ago. Back then, man-powered flight was still half a century away. Railways were the high technology of the day, and it would be a long time before women would be granted the right to vote. People would be born and would die before the First World War would be fought, and the debilitating economic depressions of the late 1800’s were a full two generations away.

Yet that was the last time that the 30 year return for bonds exceeded the 30 year return for shares. For a little more detail on that, refer to the financial website…

US Civil War photo

150 years is a long time ago - and a very different world

Let’s ponder that one just a little bit more. This was the most recent time in which the 30 year return for investments in fixed income securities was greater than the return from taking a risk and investing into shares. In other words, the “risk premium” for taking on the additional risk of investing into equities over that from investing into debt, was negative.

This may not seem like a big deal. It may not even make the news tonight. However, this is arguably one of the biggest financial events to hit the global financial markets in 150 years!

Am i exaggerating? Maybe. Here in Australia, interest rates have been low but fairly steady. Our Reserve Bank Governors have done as good a job as could be expected, in navigating an economy through a terms-of-trade boom bigger than any faced in recent memory. Investment into shares has outperformed investment into fixed income securities over 30 years. We won’t bother to check that today (but you are welcome to do so, and feel free to contradict me should you find that the facts show otherwise) but the American result should cause us all to pause for a moment and reflect on the terms under which our “long term” plans are based.

For now, let’s just say that the role of the financial planner as an investment adviser, has just become that little bit more difficult. The things learned in Financial Planning 101 aren’t necessarily turning out to be as solid a foundation as they were supposed to be. So when people suggest that 6% as a term deposit rate is a pretty good rate of return, it is a reasonable statement, given the broad global financial environment. That doesn’t make it right for the next 30 years but it does make it a far more interesting discussion than it has been in a very, very, very long time.

Long Term Interest Rates

Aside from the fact that today  i lost $2 on a nag that i am not sure has even finished the race yet, the Reserve Bank of Australia (aka “RBA”) reduced Australia’s official interest rate by 0.25% today. That means interest rates are down a bit. Still quite a bit higher than their post GFC, April 2009 low point of 3.0% but down a fraction, from 4.75%  to 4.5% at the moment.

Australia’s 10 year bond rate has altered a little bit in response to the expectation of this cut.

However, the US of A is the “reserve currency” of the world. That means it holds a very high level of respect as a “liquid” place for short term funds. It is basically the benchmark against which other currencies are judged. Similarly with interest rates. If the world’s biggest economy is running at close to zero interest rates as an official position then you’d expect the 10 year interest rates to be correspondingly low. And so they are. The inability of the EU governments to get their act in order means the $US is seen as a “safe haven” in times of worry. From a personal viewpoint, i see this as a reflection of the US as a base of most of the global speculative dollars at the moment but that is just an uneducated guess on my part. Whatever the causes, when global finances seem at risk, money floods into the US (or is it “back to the US?”). This means money flows into short term Treasury notes and US fixed income markets. When the world of money is most at risk, the money flows most to the most indebted nation on earth – the US of A. This actually drops the cost of funds for the earth’s biggest debtor. Here is a chart of the US 10 year interest rate over the last couple of decades…


USA 10 year bond rate over the last decades

So you borrow more, and your interest rate keeps going down...?

For those remotely interested, the US 10 year interest rate changed 8% last night… 8% in one night! That may have been caused by the failure of MF Global (one of the 22 Primary Dealers allowed to create markets for US Treasuries) but regardless, does it make sense for the USA to be paying so little for its massive debt level?

Remember that interest rates going down on a long term fixed income investment (like a government or corporate bond), result in the price of that investment going UP! This means that when things look particularly bad on the economic or corporate front, more money goes into these fixed income areas, which increases the return of those already holding those investments. However, like the child game of musical chairs, when the music stops those holding the securities will see the value of their investments fall, as interest rates rise again. This is not a prediction for rising or falling rates, just a statement of the mechanism under which bonds and fixed income securities operate.

Those in term deposits will feel good about their holding, as the face value does not appear to change with changing interest rates but this is really just an issue of timing. Term deposits are generally more secure than longer term bonds and securities but the interest rate changes will eventually impact when the deposit matures, so it is more a case of the long term securities reflecting the long term income expectations, and this is the way such measures are approached when financial planners look at portfolios that include a mix of these different types of investments.

Financial Planning timeframes

This is the big issue moving forward. With interest rates moving down in the short term, expect to see more and more commentary on the outperformance of bonds over shares. However, when you are reading or watching any of this, remember that this is an “outlier event”. That is, bonds are in a golden period right now, as money is taken out of shares. This is understandable, given the losses sustained in the GFC, and the tirade of negative press that pre-empts, reports on an reviews, every new headline on financial markets. This is the time where people begin to think that cash will always be a good place to hold money, where bonds look like a great idea and where doubt will be cast on all long term plans.

We will continue to ponder this area of financial planning, as it will be fundamental to how people view their retirement and medium term plans.

Is Financial Planning a Mug’s Game?

This was my initial statement, and it is a little tongue-in-cheek… but not much. Many of the long held assumptions which underpin financial planning are now being cast in a doubtful light. It does not necessarily mean that those assumptions are wrong or that your financial planner is devoid of knowledge of where these conundrums lay.

It does mean that the financial planning process will need to include more time for simply discussing the broader environment – and this is something that most people are bored of hearing about, and it is NOT something that most people are happy to be charged on an hourly rate to listen to!

We will look at the longer term returns for shares, bonds, managed funds and the like over the coming months. I have already prepared a large amount of data on these points but it takes time to distill it into something that is worthwhile.

There is also the problem of “survivorship bias”, which means you only get to measure those investments and ideas that worked, and are still around. Those which failed are no longer around and usually do not count in statistics or standard measures, giving everything a more rosy gloss than may be deserved. We’ll do our best to account for this, and i trust you will find the information to come will be of some help in understanding the nature of “long term” as it applies to financial planning, and how distortions and misconceptions can lead to bad decisions.

Financial planning is not really a mug’s game. It’s an exhilarating and rewarding profession, and we planners get to help people work through their finances over the long term – and seeing long term plans come to fruition is about as good as it gets for a workplace outcome, don’t you think? In times like these, even financial planners possess and exhibit doubt. That is a good thing, as it indicates a willingness to poke and ponder and test rules and ideas. Let’s continue to do this as we work through some of the challenges and issues facing financial planners – and people dealing with financial planners – in todays’ rather strange operating environment.










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