Paper loss has real bite

By BRENT SHEATHER

There are about as many views as to what constitutes sound financial advice as there are advisers.

In part, that's because an individual's perception of risk depends on personal factors as well as age, wealth and experience; for example, many New Zealanders in their 70s, born in the Depression years, remember their parents' warnings about avoiding debt, shares and so on - and that has affected financial decisions all their lives.

Research by consumer groups in this country and Australia highlights the fact that there can even be huge variations in the advice provided by employees of the same advisory firm.

Furthermore, the short term rules; despite all the warnings, immediate past performance plays a powerful role when advisers suggest how their customers' assets should be invested.

For example, if you were unfortunate enough to seek professional financial advice in 1999-2000, you were more than likely loaded up with international shares - not because they were cheap or made lots of sense in your portfolio, but because they had performed so well and were easy to sell.

Nowadays, however, it is relatively safe to seek financial advice as your adviser has most likely lost a lot of money on international shares and is in a far more sober and practical frame of mind.

The adviser may even ask how much income you need from your lump sum. Don't count on it, though - despite attempts to legitimise their antics via diplomas and professional associations, there is still way too much bravado and buffoonery in the financial planning industry.

Although volumes have picked up, it is still relatively tough out there for financial advisers; the phones aren't ringing and there is not a lot of new business being done.

Despite the recent rises in overseas share prices, many investors are still looking at a big paper loss compared with the markets' peak.

Damage control is very much the name of the game - reassuring mum and dad that, despite the big hole in their nest-egg and the gaping discrepancy between actual cash received and what the original plan spreadsheet said their annual income would be, they should keep paying the monitoring and management fees because "things will be okay if they hang in there".

One of the favourite arguments used by advisers is to play down the significance of the big negative figure representing your portfolio's capital depreciation by describing it as "only a paper loss". In other words, it is somehow not real, not a worry and, by implication, your adviser who recommended such a high weighting in international shares is not an idiot.

The "only a paper loss" argument seems to suggest that the stockmarket is an irrational pricing institution which, having overreacted to September 11, the Iraq war and Sars, will bounce back again. One has only to hang in there and things will be "right as rain" shortly.

This theory is, of course, more nonsense in the same way that the popular prediction of a 10 per cent annual return on shares, after fees and tax, in many clients' original retirement plans was.

Earlier this year AMP shares fell about 37 per cent in one day. Was the A$4 billion ($4.5 billion) cut in the value of Australia's 10th biggest company also just a paper loss that shareholders could cheerfully ignore? Of course it wasn't - things had gone desperately wrong at AMP.

The resulting fall was not unusual, it was not illogical, it was the free market in operation, adjusting prices to reflect changed circumstance.

Stage one finance texts tell us that a share price reflects the net present value of all the future cashflows the company is expected to receive, so a fall in a share price probably means that the "market" expects a fall in profitability and/or an increase in the riskiness of these profits.

The technology sector in the US fell harder than most sectors, partly because the "market" no longer believed that its profits were likely to keep on growing three times as fast as those of businesses in other areas of the economy.

Intel shares are down by 65 per cent from their peak for good reason - it's getting tougher in the real world. Paper losses reflect real problems.

The "only a paper loss" illusionists are in some ways being quite smart because, while it is a distortion of the facts and may or may not be bad advice, behavioural finance texts tell us that this is exactly what many investors want to hear.

In his book Beyond Greed and Fear, Hersh Shefrin of the Harvard Business School lists loss aversion as being a major feature of many people's investment strategy.

"Most people ... have great difficulty coming to terms with losses," says Shefrin. "Consequently, people are predisposed to hold their losers too long, and correspondingly sell winners too early."

Shefrin cites an excerpt from a manual for stockbrokers describing the difficulties investors face in coming to terms with losses. "Many clients, however, will not sell anything at a loss. They don't want to give up the hope of making money on a particular investment, or perhaps they want to get even before they get out.

"The 'get even-itis' disease has probably wrought more destruction on investment portfolios than anything else ... " "

There just might be a reason to trot out the "paper loss" scenario if, in 2000, sharemarkets had been fairly valued and had now fallen well below historic average valuation levels.

Alas, this is not the case. Today many of the world's stockmarkets, the US in particular, remain expensive based on historic precedent. To reach 1999-2000 levels again will require either unusually rapid economic growth or a new mania.

Again history suggests that another bout of "irrational exuberance" won't repeat until the last one has been well and truly forgotten.

In contrast, advising clients to sell implies that "we made a mistake", and runs the risk of losing one's credibility, the client and those fees. Most investors who get to this "what shall we do?" situation get there because their original financial plan assumed that their stockmarket investments would serve up capital gains each year.

Three down years in a row have shown this model to be totally unrealistic.

The recognition that, not only is their capital going down but that it is producing minimal income after fees, leads many investors to have second thoughts.

Research by London Business School economists Dimson, Marsh and Staunton shows that stockmarkets can take a long, long time to recover; the oft-cited US research which shows that anyone investing for 20 years is virtually guaranteed a positive return is exceptionally favourable compared with many other markets.

The Dimson, Marsh and Staunton calculations also use gross sharemarket indexes, which include dividends, but in reality most retail investors don't receive dividends from international shares because they are used to pay fees.

Excluding dividends, even the S&P 500 index - a widely-used measure of the US stockmarket - took 25 years to recover after the 1929 crash.

Whether you should "hang in there" depends mainly on whether you can afford to. For example, international share trusts pay next to no dividend - are you able to tolerate negligible income from these for a further five years?

If you need the income, then your portfolio asset allocation was worked out wrongly in the first place. For anyone in that situation, paper losses mean real world hardship.

It may be that selling some international shares producing little or nothing in dividends, in favour of cash-producing assets, is the right thing to do.

It is not at all clear, however, that just because shares have fallen from their peak they must return to those heights any time soon.

* Brent Sheather is a Whakatane investment adviser