The last few years have seen a growing appetite among South African investors to take money offshore. The combination of poor returns from the JSE, a weak economy and political uncertainty has encouraged many people to invest elsewhere.
Most would claim that this is diversification, and that diversification is always desirable. However, just taking your money somewhere else is not necessarily diversifying your portfolio.
As David Nathanson, global equity specialist at Bellwood Capital, explains many South Africans think that global diversification is about fleeing risk. However, he believes this is a misconception.
“Diversification is about managing risk,” he says. “It is not about avoiding or eliminating risk, which cannot be done without sacrificing investment goals. It also isn’t about trading one risk for another, presumably lesser, risk, nor should it be about taking risk indiscriminately for the sake of diversification.”
To explain this, he points out that there are two broad components to an investment process.
“The first is selection,” he notes. “Whether that be country or stock selection. This part is about looking at different countries or stocks, assessing the risks, assessing the potential return, and deciding if you would hold them.”
This cannot just be an evaluation of risk, because it must also consider the potential return. This is certainly worth bearing in mind when considering South African assets at the moment.
“I’ve heard people make excellent cases for investing in South Africa now,” Nathanson says. “Valuations are depressed, the market is cheap, the rand is weak, and we could see good returns from here. On the other hand, I’ve seen people make very good cases against South Africa, looking at the political risks, what’s happening with state-owned enterprises and our national debt.”
At this stage of the investment process, you are only assessing whether or not a country or stock is worth investing in.
“South Africa has risks, and it has a potential return, but assessing that is about stock or country selection,” says Nathanson. “It’s not about diversification.”
That comes in the second part of the process, which is when you consider all of the investments you would be happy to hold, and decide how to allocate between them.
“At this stage you have to decide how much risk you are willing to take with any one of those investments,” Nathanson explains. “How many of them do you want to spread your money across?”
Part of this could be thinking about how much risk is too much to take.
“For example if you’re looking at South Africa, what is the probability of something going horribly wrong and you losing your purchasing power in a global sense?” he asks. “If that is a risk you are concerned about, then you wouldn’t put everything here even if you had a positive view of future returns in South Africa. That is diversification.”
Importantly, this is true of other individual countries as well.
“It doesn’t help to say I’m scared of the risk in South Africa, but I’ll put everything in the UK or Australia,” says Nathanson. “You are making the same mistake essentially.”
This is something investors sometimes forget when they are simply trying to flee risk.
“Fleeing is saying I’m scared of South Africa and so I want to go to the UK,” says Nathanson. “Over the last five years that wouldn’t exactly have helped you either because returns have been very similar. Fleeing risk is a basic way of thinking about diversification, and it’s wrong.”
Taking good risks
Investing offshore therefore does not mean that you are eliminating risk. It is rather about managing different risks.
“Every investment you make has risks,” Nathanson explains. “Even so-called risk-free cash investments have default or inflation risk associated with them. So there is no investment that comes without risk.”
What investors should be doing, however, is making sure that they take good risks.
“Those are risks where the expected return is commensurate with the risk you are taking,” explains Nathanson. “Managing risk is also about not over-exposing yourself to any one source of risk, and having uncorrelated risks, such that if something goes wrong in one part of your portfolio, you will be protected by others.”