Re­ward

Finweek English Edition - - INVESTMENT -

Ev­ery­body ac­cepts that risk and re­ward are two crit­i­cal parts of in­vest­ing, but do we re­ally un­der­stand the equa­tion and are we man­ag­ing it prop­erly within our in­vest­ment portfolios?

In the first sense it is ex­actly what it says, if your po­ten­tial re­ward is high then equally your po­ten­tial risk must also be high. We un­der­stand this, but we of­ten do not re­ally take cog­ni­sance of the ac­tual risk. So we find a small-cap stock that looks like it could shoot the lights out and put some of our hard-earned cash into the stock. Then, in­stead of per­form­ing well, it col­lapses into a heap los­ing say 90% of its value. A few things have hap­pened here, the ob­vi­ous be­ing a de­struc­tion of great wealth, but there is some­thing even more im­por­tant that we fail to fully un­der­stand. Say we in­vested R5 000 into the stock, a 90% loss means our in­vest­ment is now worth a very mod­est R500. The re­al­ity is that in or­der to get back to breakeven, we need the cur­rent price to im­prove ten­fold. In other words, if this stock does a ten­bag­ger on us, we’re merely at breakeven. What are the real odds of that ten-bag­ger? I would sug­gest close to zero.

So it is more than just risk ver­sus re­ward, it is also about re­coup­ing that loss if the risk side of the equa­tion plays out.

An­other is­sue is why we swing for the fences tak­ing ex­tremely risky po­si­tions – we’re try­ing to get rich in a hurry. So let’s look at that side: your in­vest­ment in­creases in value ten­fold and – a real ten­bag­ger. Your R5 000 ramps up­wards and be­comes worth R50 000. That’s great, but is it life-chang­ing? That amount could buy you a great weekend away, but you’re cer­tainly not re­tir­ing early on a mere R50 000. The point here is that while the ac­tual re­ward is ab­so­lutely at­trac­tive, it is not life chang­ing, yet a string of losses could be ru­inous. Sure, we could do a bunch of ten-bag­gers in a row, then things would be dif­fer­ent but that’s never the case.

So we go out on a limb with real downside risk and while we fo­cus on the re­ward, we for­get the im­pli­ca­tions of the risk. For ex­am­ple, if it took us a year to save that R5 000 then we’re now a year be­hind in our in­vest­ment strat­egy and po­ten­tially re­tir­ing a year later.

If the R5 000 had been in­vested into an ex­change-traded fund av­er­ag­ing a de­cent 18% per year re­turn that money, would dou­ble in value ev­ery four years. Sure, you’re not get­ting rich in a hurry but this can be life chang­ing in time. Imag­ine adding R5 000 ev­ery year and see­ing it dou­ble ev­ery four years? Af­ter a decade you have in­vested R50 000 (a de­cent amount by any met­ric) and if it all grew at 18% a year, you would have a port­fo­lio of al­most R140 000! Now we’re talk­ing and you’re only in­vest­ing R5 000 a year ( just over R400 per month). In other words, with­out shoot­ing for the stars and with­out tak­ing on­board se­ri­ous risk, you are cre­at­ing real wealth.

If we carry on with the above ex­am­ple, in­vest­ing R5 000 per year and grow­ing it by 18% a year, af­ter 20 years the port­fo­lio is some R865 000. Af­ter 30 years we’re al­most at R4.7m and af­ter 40 years the value is al­most R25m! Of course inf la­tion has eroded the value of that R25m, but the R5 000 you started with is now just small change.

The big­ger pic­ture is that we do not need in­sane risk if we give our­selves time. The per­son go­ing for high risk may have a few win­ners but, in truth, has had a lot more bust-outs and prob­a­bly has a port­fo­lio that is close to noth­ing while opt­ing for the more long-term op­tion with lower risk has reaped real wealth.

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