SERIOUS MONEY:ALBERT EINSTEIN once quipped that compounding is "the most powerful force in the universe".

The power of compounding is a particularly attractive feature of equity investment, but pension fund trustees will be all too aware that it can operate in reverse. The damage of two major cyclical declines in the past eight years has seen most funds plunge from surplus to deficit, and nothing short of a miraculous investment performance will see these shortfalls overturned in the short run.

Recently published performance statistics courtesy of Rubicon Investment Consulting provide cause for considerable anxiety among trustees.

The average pension managed fund has registered a 23 per cent decline since last June before inflation, and needs to generate gains of almost 30 per cent just to eliminate the nominal losses incurred over this short period.

More alarming is the fact that only one manager has generated inflation-beating performance over the past decade, with the typical fund losing more than 10 per cent of its purchasing power – the only metric that matters – since the summer of 1998. A myriad of excuses has been put forward for the dreadful performance, but none stands up to serious scrutiny.

Trustees are advised to be patient as equities, despite their short-term volatility, have historically provided significantly higher returns than bonds over long periods. Indeed, some argue that more than two centuries of data show that US stocks have outpaced bonds 99.5 per cent of the time over a 30-year horizon.

However, even a first-year statistics student should be more than equipped to detect the invalidity of this argument, as the data using non-overlapping periods can easily be manipulated to demonstrate the equally invalid proposition that the probability of stocks beating bonds over 30 years is close to 80 per cent.

A limited data set of little, if any, statistical significance should never be used to reach broad conclusions.

Furthermore, the American experience should be viewed as a special case given that it is inconceivable to believe that anyone could have foreseen two centuries ago the economic powerhouse that the US would later become. Indeed, the limited history has not been so kind to other markets.

Statistics since 1900 show that Japanese, French, German and Spanish equity investors would have needed an investment horizon of 50 to 60 years to be assured of a positive real return, while Belgian and Italian investors had to wait more than 70 years.

Irish investors had to linger almost a quarter of a century before stocks broke even in real terms. Are you that patient? It seems stocks are not a sure thing after all.

The notion that stocks are safer for long-term investors rests not only on history but also upon time diversification, or the idea that risk declines with time.

Intellectual heavyweights such as Paul Samuelson and Robert Merton, both Nobel prizewinners, have independently argued that this belief is simply not true given the assumption that annual returns are not serially correlated, ie random.

Samuelson proved his case in a 1963 paper where he recalls an encounter with a colleague who refused to accept a gamble with favourable odds on a single coin toss, but agreed to a series of 100 tosses with the same odds.

Acceptance of the serial bet is illogical because the magnitude of loss increases exponentially with time, offsetting the declining probability of loss. In other words, the decision to accept or reject the gamble is independent of the number of coin tosses.

The argument can be equally applied to equity allocation and, given the underlying assumptions, the proportion of monies invested in stocks should be independent of time.

The fact that stock returns have historically outpaced those of bonds is a necessary but not a sufficient justification to maintain a heavy weighting towards equities irrespective of a fund’s demographic profile.

The fact of the matter is that stocks are safer for long-term investors if returns exhibit mean reversion, ie bad periods follow good periods and vice versa.

Equity returns are indeed mean-reverting and equity markets are currently eight years into a new bear cycle, a phase which just as now has historically been characterised by declining valuations and savage intermittent drops in prices.

Unfortunately, investment managers do not appear to believe in mean reversion, which negates the long-term case for equities, and some are clearly operating under the illusion that the 1980s and 1990s were the norm.

Fund managers may also argue that the current bear market has been particularly brutal for Irish stocks and their performance given current allocations, but such a defence flies in the face of the sound case that some have been making regarding the need to be well-diversified.

The easily diversifiable risk to which pension funds are exposed cannot be defended sensibly. The overweight positions in domestic financials and the negative impact caused by disappointing news emanating from both Elan and Ryanair cannot be justified.

It will be argued that the current turbulent period was totally unexpected, which somehow vindicates poor performance.

However, the fact that US house prices were changing hands at valuation levels three standard deviations above historical norms was plain for all to see, as were the deteriorating lending standards. The timing of the eventual fallout was clearly not predictable, but its inevitability was far from uncertain.

It is clear that investment performance over both short and long horizons has been poor.

Some fund managers, however, have consistently outpaced their peers over all horizons, while others have time and again found themselves near the bottom of the list.

Hard questions need to be asked of an industry that must do better and those consistent under- achievers must be taken to task.

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