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The risk of being too cautious

And benefits of staying invested for the long term.

The start of 2017 has been markedly different to that of 2016; the first two weeks of last year were characterised by ‘Nenegate’ aftershocks as well as the worst start in history for the S&P 500. While 2016 did improve, the calendar year provided for lacklustre returns with the JSE All Share Index (Alsi) delivering a total return of 2.6%. The best-performing asset class was local bonds, albeit on the back of a terrible December 2015 (Nene firing). Thus far, 2017 has seen the strengthening of both the local currency and stock market. Added to this positivity, although on a different tack, NFB Asset Management, the asset management business in our group, won the Raging Bull for the best multi-asset class fund (NFB Ci Cautious FoF) on a risk adjusted basis over five years. 

What do market returns and awards have to do with this article? Firstly, at the moment investors are disillusioned after two years of single-digit returns and are looking towards cash as a solution; risk off. And secondly, it is possible over a reasonable time frame to get decent returns, in excess of cash and inflation, without taking on unnecessary risk.

In an interview with Moneyweb editor Ryk van Niekerk, towards the end of last year, I mentioned that a regular risk our business encounters is that of investors being too conservative. Last week, an event that really got me thinking of this article goes as follows: a client instructed us to redeem her investment as she was going to put the proceeds in her bank account. She is a relatively low-risk client and as such, her funds were invested in a blend of cautious funds which have a moderate-cautious (maximum 40% equity) risk profile. Since July 2011, she has enjoyed an average return of 8.4% (net of all costs) per annum, which comfortably beats cash and inflation over that period. The redemption upset me as I know the client could do with the best return possible, and this return isn’t going to be from cash over any meaningful period. My feeling is that she’s doing herself an injustice; I can understand the client’s disappointment in the return if we look at 2016 in isolation, a much stronger rand and just 2.6% from the Alsi negatively impacted most multi-asset class solutions, but investing is not a ‘one-day game’. Over a period of ten years the difference of an extra 1.5% return per annum compounded is significant. If we compare returns of 7% and 8.5% p.a.; you would enjoy an enhancement of R293 832 from the extra 1.5%, which is equivalent to just under 30% extra on your starting capital. The longer the period you are dealing with the greater the positive impact of any extra return earned. The potential change to your lifestyle can be dramatic, 30% more income per month can be a game changer. 

Enhancing your return above cash is not without risk. To move up from 7% to 8.5% may mean switching from cash to a low equity, multi-asset class unit trust. As soon as you move up the risk profile from cash you increase the possibility of a capital loss. The following graph compares the money market unit trust sector against the low equity, multi-asset sector over rolling three-year periods. Three years is probably too short for the comparison but I would rather be too conservative.

There are 163 rolling three-year periods in the above chart in which the South African Multi-Asset Low Equity (maximum 40% equity) sector outperformed 127 times, or said another way – 78% of the time. Another statistic from the chart is that, for this period of analysis, the average outperformance of the multi-asset, low equity sector versus cash is 2.8% (think back to my previous example of the benefit of outperformance of just 1.5%). As soon you extend the time frame beyond rolling three years, you extend the probability of beating cash significantly beyond 78%.

Another way to illustrate the benefit of staying invested for the long term, and thus a chance of a cash plus return, is looking at a chart called the ‘funnel of uncertainty’. The aforementioned chart (often done as a line chart hence its name) illustrates the range of returns you can get from an investment in to the JSE starting, for our illustration, at an investment term of one year all the way up to ten years.

For an investor who invested in the Alsi, looking back to 2001, in any one year, the best result could have been 73% but the worst could have been 38%. When we look to the best and worst ten-year period, also since 2001, the worst result is 10.5% p.a. and the best at 23.6% p.a. The range of returns has decreased from 111% to just 13.1% when moving from a one-year period to a ten-year period.

The point I have been trying to illustrate with the examples and charts above is primarily that you need to give investments a chance, and the longer you stay committed the higher your chance of beating cash. Historically, cash has never beaten inflation on an after tax basis over any meaningful term. If you do not move beyond cash for your investments, you dramatically impact the long-term purchasing power of your money by losing out on potential return. You should not take on unnecessary risk, just some risk where appropriate. I have observed the tendency to stay close to cash across the wealth spectrum which talks to our innate bias for positive outcomes.  

In general, and broadly speaking, you should take on enough risk (asset class exposure such as equity, property and bonds) to give your hard earned money the best chance of beating cash, and more importantly inflation, over time on an after tax and cost basis. The aforementioned requires sticking with your investments, with a regular review process, for a reasonable period of time and not getting nervous when the lean times arrive, because they will arrive. Make sure you understand not only the upside an investment can give you but also the downside.

ADVISOR PROFILE

Stephen Katzenellenbogen

NFB Private Wealth Management

COMMENTS   1

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Hahahaha. more buyers than sellers at the moment….just wait untill the Fed starts raising rates!

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