The fundamentals of investing

A portfolio should balances investment risk with investment returns, to achieve a more favourable result over your investment horizon.

Any investment portfolio should be based on solid research and economics. The aim is to produce and manage a portfolio which balances investment risk with investment returns (rewards) in order to achieve a more favourable result over your investment horizon. This is a well-documented and widely accepted investment fundamental, so why do so many investors never seem to achieve their desired results?

Market volatility

Possibly the greatest reason for investors not achieving their investment goals is their reaction to market volatility. As humans, we have a firmly ingrained ‘fight or flight’ instinct which has ensured our survival as a species. However, this ‘fight or flight’ instinct does not necessarily make us great investors. In fact, this instinct can very often cause us to behave in such a way that is detrimental to our investments. By way of analogy, we know that when a lion charges us in the bush, our best option is to stand our ground. However, most people – many experienced game rangers included – fail to overcome the flight instinct and will succumb to the lion’s charge. Similarly, in turbulent economic times, investors very often regard market downturns as a loss rather than an opportunity, and consider market upturns with over-confidence rather than with cautious optimism. This is referred to as the ‘fear-greed’ cycle where investors choose to invest near the peak of a market and disinvest when markets fall as emotions take control of their investment decisions.


Source: Old Mutual Wealth (click to enlarge)

More recently, both global and local investment markets have had a torrid five years ending 2018. To put this into perspective, in the past five years growth assets (i.e. shares and equities) have under-performed in relation to cash for only the 6th time since 1900 on a rolling five-year analysis. The graph below, provided by Investec, demonstrates this phenomenon very well.

Source: Investec (click to enlarge)

The graph above demonstrates that if an investor had held his money in cash in the five-year period ending 2018, he would most likely have generated more favourable returns that if he had remained in a diversified equity portfolio. However, over any six-year term, his equity portfolio would out-perform a cash investment. If we extrapolate this to a 25-year investment period, his cash investment would generate returns of inflation +1% per year, whereas his equity portfolio would achieve returns of inflation +8% per year. In simple terms, this is the difference between his money doubling every 72 years (in a cash portfolio) versus his money doubling every 9 years (in an equity portfolio).

Beating inflation

The primary purpose of investing is to beat inflation. Investors essentially have the option to invest in

(i) shares or equities, (ii) property, (iii) bonds and cash, and (iv) a combination of the above. Historical investment data reveals that an investor can expect before-tax investment returns of inflation +1% from cash and inflation +2% from bonds. It further reveals that investors can expect inflation +4% from property and inflation +6% from shares. In a nutshell, the greater the investment risk, the greater the investment reward. However, remaining steadfast in times of market volatility and staying focused on the long-term goals are key to the success of such an investment strategy. While cash never produces negative returns, bonds, equities and property can and do – over the short-term. Over the long-term, equities, bonds and property have always out-performed cash.

Asset class performance over 20 years

The table below demonstrate the asset class performance over the past 20 years, assuming a tax rate of 30%. Each block represents the single-year performance of each asset class. The green highlighted blocks show the years in which negative returns were experienced.

Calendar with 30% tax

Source: Old Mutual Wealth (click to enlarge)

As is evident from the above table, cash has never had a negative year. This means that, if you were invested in cash, you would never have less money than what you invested the previous year. However, cash returns have seldom beaten inflation which means it achieves no tangible growth in real terms. If your cash returns just keep pace with inflation, you will experience no real term growth on your investment over time. If you are aiming to spend R30 000 per month for a period of 25 years in retirement, while achieving no market returns, you would essentially need to have R9 million available (R30 000 x 12 x 25) in today’s terms to afford your retirement.

Portfolio construction

An investment plan should be custom-designed to provide you with an optimised blend of the four assets classes so as to achieve the most favourable result over your investment horizon. While investing in cash may satisfy you in the short-term because of the lack of market fluctuations, you will experience disappointment over the long-term. If you were to invest in cash and start living off your savings, the effects of inflation will quickly catch up with you and you will have to draw from your capital. Should this occur, you will be forced to re-enter the investment markets with a reduced timeline and a need to take investment risks, which is certainly not ideal.

The role of the financial advisor

One of the key roles of a financial planner is to partner with investors to guide them through periods of volatility and uncertainty. The nature of investment markets is such that there will always be short-term losses, and it is during these times that we need to keep perspective. On the other hand, there will also be periods of exceptional gains during which we need to remain grounded. For instance, in December 2018, the US markets saw its biggest fall (9%) since the Great Depression. However, the JSE experienced a 7% growth in the first quarter of 2019 – its best 1st quarter since 2007. It is therefore important for both you and your advisor to understand your needs and objectives, and to construct and manage your portfolio accordingly.

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Gareth Collier

Crue Invest (Pty) Ltd


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