Is your investment successful?
There’s more than one way to measure success.
When comparing investments the buck tends to stop at returns.
Returns are easy to compare. One fund returned 12%, another returned 10%. It feels like an obvious way to judge an investment. I’ve recently written why that’s not the full story.
An underappreciated part of the story is how those returns were achieved, how consistent they were, how much risk was taken, and how much tax was paid along the way. The only thing that matters is how much ends up in your bank account.
Imagine two portfolios that each produced an average annual return of 9% over the past decade. A fair assumption would be that the portfolios would have identical outcomes – dollar for dollar.
Portfolio A experiences relatively modest declines during market downturns, generates tax-efficient returns and produces reliable income throughout retirement. Portfolio B suffers several large drawdowns and generates significant taxable distributions while inducing poor behaviour from volatility.
The journey is important because the average return may be the same, but the end outcome is not.
Risk is not just if your investment falls, it is also by how much
Many investors conflate risk with volatility. It is helpful to think about risk in a more comprehensive way. Risk may include how volatile an investment is but there is also the added nuance of the size of the fall and the recovery time.
Larger losses require disproportionately larger gains to recover.
A portfolio that falls 10% needs to gain 11% simply to break even. A portfolio that falls 40% needs to gain almost 67%.
Source: Morningstar Investment Management
Downside capture: losing less can be just as valuable as gaining more
Rather than asking how much an investment gained during good markets, downside capture measures how much it fell during poor markets. For example, the market falls 10%. Investment A falls 10% and Investment B falls 7%. Investment B has captured only 70% of the market downside.
This may not seem as exciting as outperforming the market, but over long periods, downside capture can make an enormous difference. Losing less during market declines means less ground needs to be recovered during the subsequent rebound. Compounding works more effectively because you’re building from a higher base.
Many investors chase the highest returns during bull markets without paying enough attention to how their investments behave during bear markets.
Volatility matters more than most people realise
Investors often say they have a high risk tolerance. Then they experience it. Market volatility isn’t simply a mathematical concept as it also affects behaviour. The more dramatic the swings in a portfolio’s value, the harder it becomes to stay invested.
Morningstar’s Mind the Gap research has consistently shown that investor returns often lag fund returns because people buy and sell at the wrong times. You can read more about our investor behaviour research here.
A smoother investment journey doesn’t just improve sleep. It can improve long-term outcomes if it helps investors remain disciplined through market cycles.
Tax efficiency can quietly add significant value
Returns are usually reported before tax. I recently wrote about how tax alpha is becoming more important for investors. In lower return environments, optimising your portfolio can make a real difference.
Investors spend after-tax dollars and two investments with identical pre-tax returns can produce very different after-tax outcomes.
Tax efficiency comes from several sources. Some investments trade less frequently, reducing realised capital gains. Others make greater use of franking credits or international tax treaties.
As an example, in recent years several funds made unexpectedly large capital gains distributions. These distributions create tax obligations despite investors not selling any units. The headline return may look attractive, but some investors received a tax bill they hadn’t anticipated.
For long-term investors, after-tax returns, not headline returns, are ultimately what matter.
Income stability matters for some investors
Not every investor has the same objective. Someone accumulating wealth over several decades may care little about annual income. However, someone approaching retirement may value stable income even if total returns are slightly lower.
/An investment that produces predictable cash flow can reduce the need to sell assets during market downturns while concurrently reducing tax consequences.
Retirees often benefit from understanding not just how much income an investment pays, but how reliable and sustainable that income is. My colleague Mark recently wrote about this. The ‘best’ investment for you depends partly on what job it needs to perform.
Success depends on your goals and proper planning
Some investors start with picking investments in their portfolios, instead of first understanding what they are trying to achieve.
Beating an index means little if you don’t get the return you need to achieve your goals – especially if the timeline matters. Examples include funding children’s university education, retiring at 55, or buying a home in five years.
Each goal may require a different portfolio, different level of risk, and therefore a unique definition of success.
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Invest Your Way
For the past five years, Mark and I have released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.
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