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Understanding the impact of time on risk can make you a better investor

The efficiency frontier – what it is and reasons for concern: Adriaan Pask, CIO, PSG Wealth.

CIARAN RYAN: Investors looking at the incredible gains made on world markets over the last year may be wondering whether they’ve missed the boat. Others may be thinking it could be time to take some profits. But as several studies have observed, timing the market is almost impossible, and those who do this tend to get it wrong. That can sometimes be a costly mistake.

Joining us to discuss this is Adriaan Pask, who is chief investment officer at PSG Wealth. Welcome, Adriaan. First of all, how does an investor’s time horizon impact their risk and return? We’ve heard about these studies that show that when you’re trying to time the market, you’re generally going to get it wrong. And people may be thinking, looking at the way markets have gone up over the last year, maybe I should just harvest some of those profits. Is that a good idea?

ADRIAAN PASK: Hi, Ciaran. Thanks for having me. In short, yes. Investors tend to make mistakes over a shorter-term period. So last year, for example, we saw when it was panic in markets investors throw their time horizons out of the window.

So, it’s all good and well to say that you’re an investor and you’ve got a plan and you’re going to stick to that. It’s for 10 years or 20 years, or whatever the case may be. But the minute a stressful situation hits, normally that 10- or 20-year plan goes out of the window. There are various academic studies that have shown that to be the case.

But I also think it’s really important to consider the impact of time on investment as a whole. To use an example, investors typically think of risk versus return, so if you think about some of the normal product ratios that you would, for example, see come through the industry, where financial service providers compare different funds, for example, they would illustrate this as [having] more risk than that, but the returns should be higher. And I think the mistake that we make is in not thinking about time in that type of analysis, because it’s also really important to frame that with the investor – not just looking at the risk and return, but also saying, this is a realistic outcome given a certain horizon. If you’re going to shorten that, it’s going to create a problem for you.

CIARAN RYAN: It’s interesting to go back and look at these various crashes that have happened in the market. If you go back to 1987, and the one that happened in the early 1990s, also the one that happened last year, there was a more than 30% drop in the market. A lot of people got panicked and jumped out of the market. But when you look at the longer-term horizon, that 1987 crash looks like nothing. So the point is that the longer you stay in the market, the more likely you are to actually gain in the long term. Correct?

ADRIAAN PASK: Yes, absolutely. I think that’s one component of it, but [there’s] also understanding how different asset classes behave over time. To take an example, if we look at equity returns over a one-year period since the mid-nineties, the best return over a 12-month period was 73%, the worst being 38%. So, over a one-year period that spread is 111% from best to worst. So I think it’s fair to say we don’t know what equity markets will do over a one-year period.

But what’s really interesting is, if you look at that same example over a 25-year period, for example the best return over a 25-year period versus the worst return over a 25-year period, that difference is less than 1%. So we can see the returns [are] what they call ‘mean reverts’. It’s just saying that they generally tend to move towards their long-term averages. So even though you have the short-term distortions of -38 or +70% over short periods, typically they move to something that’s a little bit more solidified in time, like inflation or GDP or whatever the case is. Those are the things that ultimately drive returns over the long term where, over the short term, it’s largely sentiment – which could be a very dangerous thing to follow as an investment indicator.

CIARAN RYAN: So what is your approach to assessing risk versus the asset class that you’re investing in, and what approach are you taking when it comes to your investment portfolios? How are you going about assessing these different risks and the outlook now for, let’s say, not necessarily a one-year view, but maybe a three- to five-year view?

ADRIAAN PASK: Yes, I think it’s also important. I’m talking from a wealth-manager perspective, and we tend to think of things a little differently from what a conventional asset manager would, maybe. We run our portfolios for our wealth-management business, so it’s really important that we understand how these fit into our wealth-planning proposition as a whole. Why I mentioned that is, if you look at something simple like inflation, it becomes a really, really important risk to consider. If we think of returns of cash and equity over a period of 20 years, for example, the likelihood of cash underperforming inflation is much higher than the risk of equity underperforming inflation. So if your risk is inflation, then rather steer clear of cash.

And that’s also very true for the prevailing market. We sit with very low interest rates, and we see that our investors who steered away out of equities into cash are not beating inflation after cost and taxes. So it’s really important that you have that longer-term mindset.

Realise that this is a 20-year plan in terms of your equity investment, and you need to make peace with the short-term volatility; it’s just part of the performance signature.

But you’re managing a much bigger risk from the long-term inflation risk, or the risk of not reaching your goals, for example. Then you tend to think of that a little bit differently.

But as the portfolios go, we follow an approach where we now diversify well, and we outsource a lot of the investment management to some of the best investment managers in the country. They will effectively allocate capital to the areas where they think there are opportunities.

But that means very little if asset managers are doing their best to put portfolios together, and the team on the wealth side is doing their best to build a client portfolio that’s sensible – but then an investor panics over a one-year period. So although it’s perfectly understandable, that long-term picture and the long-term context and mindfulness is super-important.

Actually, when the stakes are high, like last year, it’s one of those ironies that typically investors are much more prone to remember the importance of long-term investing when everything’s going well. And for some reason, when things get difficult over the short term, then there’s a problem. That’s really what creates the issue in terms of timing the market as well.

CIARAN RYAN: There’s been a lot of discussion about the ‘efficiency frontier’ in asset classes and in the markets. Just explain what that is, and is it something that we should pay attention to?

ADRIAAN PASK: Yes, I think the efficiency frontier is basically the graph that I mentioned earlier that is so often used by service providers to explain relative riskiness and relative returns, and so on. But the problem with that specific illustration is that it doesn’t take into consideration time. So that efficiency frontier – apologies for the short academic reference – but what the efficiency frontier ultimately does is to compare the risk and return for various securities or portfolios on the line. And then you can choose from there, given a certain level of risk for required return, what it is that you need.

But I think my argument is more to say that if you look at a graph like that, it’s a snapshot in time.

But if you take, for example, two identical portfolios, the risk can actually be quite different, depending on the time horizon that you apply to them. So if I’ve got a full equity investment but my horizon is a year, and someone else has a full equity investment and his horizon is 25 years, I would argue his portfolio is far less risky than mine, But the efficiency frontier doesn’t really incorporate that type of thinking.

CIARAN RYAN: Give us a practical example of how you would use the efficiency frontier in actually structuring a portfolio.

ADRIAAN PASK: Yes. Generally, what it means is that you need to look at the expected returns and the expected volatility for various asset classes and securities, and then you structure them in such a way that you get some type of diversification.

For example, if you’ve got some offshore exposure in your portfolio which has become something that is very favoured at the moment and you want to offset some of the currency risk you can, for example, invest in some domestic bonds. Or the investment case would apply from the other side as well. If you prefer some domestic bonds, but you would like to hedge yourself against a default, then you can use some of the offshore exposure.

And then you can plot various portfolios on that. But as I say, even though we as a team can put that together, and we can look at the different asset classes, ultimately the most important thing is how the client will interact with the portfolio. And if you forget your appropriate timelines at the last minute, then all the work that did that was done in the portfolio itself essentially goes to naught.

CIARAN RYAN: It is an interesting point that a lot of investors don’t really consider time. The time factor can actually change during the cycle of the market, can it not? In other words, during a moment of a crash they might’ve set out to invest for a five- or 10-year horizon. A crash happens and all of a sudden, they’re looking at a time horizon of 24 hours. So how important is this in actually defining what your time horizon is when it comes to the markets?

ADRIAAN PASK: Yes, I think it’s really important. It’s one of those things that [happen], especially when investors go in without a plan. We see this. Investors engage in equity trading on their own or investing directly and often there isn’t a clear goal or outcome in mind, or a clear investment horizon in mind. And where that’s advantageous for a financial planner is it’s always something to fall back on. It sort of anchors the whole plan.

And it helps you to have realistic expectations of what your portfolio does over time because, as investment guys, it’s only a matter of time when that panic situation will hit you. And if you don’t have a clear indication of what the time horizon or plan was for that specific investment, it’s likely that you’re going to make a mistake.

But if you can put your decisions in the context of a bigger plan or bigger goal and pre-agree the investment horizon for certain funds or asset allocation, then that discussion becomes so much easier. It’s not always pleasant, but at least you can fall back on something that was pre-agreed in terms of expectations that were realistic up front.

CIARAN RYAN: We’ll leave it at that. That was Adriaan Pask, who’s chief investment officer at PSG Wealth.

Brought to you by PSG Wealth.

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It’s called – ”time decay” mate!

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