Are you tak­ing enough risk to get the re­turns you re­quire?

Sunday Times - - Money - By CHAR­LENE STEENKAMP

● Tak­ing the right in­vest­ment risks is the key to cre­at­ing wealth. To take the right risks you need to un­der­stand which risks will de­liver the re­turns you need at a level of volatil­ity that you can han­dle.

Then you need to find the fund man­ager that fol­lows the in­vest­ment phi­los­o­phy that will de­liver the re­turns you need over the pe­riod for which you will in­vest, with an ac­cept­able level of ups and downs in your cap­i­tal in be­tween.

Rob Formby, chief op­er­at­ing of­fi­cer-des­ig­nate at Al­lan Gray, says a re­cent re­port re­veals how US in­vestors are play­ing it too safe to achieve their re­tire­ment sav­ings goals. He thinks lo­cal in­vestors are also too cau­tious as a num­ber of Al­lan Gray in­vestors at­tempt to keep the volatil­ity of their in­vest­ments low.

“As an in­vestor, your risk tol­er­ance is key to your fi­nan­cial free­dom. While all in­vestors want to avoid los­ing cap­i­tal at all costs, play­ing it too safe, or be­ing too con­ser­va­tive, can re­sult in the loss of long-term re­turns.”

To those shy­ing away from risk, Formby says: “In the short run, your money is prob­a­bly safe, but the re­turns that a money mar­ket fund of­fers may not keep up with in­fla­tion over time. In the long run, re­turns will not be enough to sus­tain you in re­tire­ment.”

The con­verse also ap­plies, he adds.

“If risk is un­der­es­ti­mated, the ups and downs may be too much to bear for an in­vestor and may force them to with­draw be­fore an in­vest­ment has had time to give them their re­quired re­turns, or they may exit at the worst pos­si­ble mo­ment.”

Ide­ally, you should de­ter­mine the in­vest­ment risk you re­quire to de­liver the re­turns you need — that is, the targeted re­turn you need to make your in­vest­ment grow to the re­quired amount over your cho­sen time hori­zon. Think about the risk you take rel­a­tive to the per­for­mance you need and then assess if you can tol­er­ate that risk, as this in­flu­ences the in­vest­ment choices you make, Formby says.

He sug­gests you work out what in­vest­ment draw­down or fall in your in­vest­ment you can tol­er­ate with­out be­ing spooked, and match your tol­er­ance with the kind of in­vest­ment you need. Gen­er­ally, the higher the eq­uity ex­po­sure, the higher the fund’s risk.

“A suc­cess­ful in­vest­ment is when there is a match be­tween the risk you ex­pect and the ac­tual risk of the fund,” he says.

Paul Bos­man, an eq­uity an­a­lyst and port­fo­lio man­ager at PSG, says your big­gest risk is that of not achiev­ing the re­turns you re­quire. You should con­sider in­vest­ment risks and the re­turns you earn over the same pe­riod. Don’t fo­cus on short-term draw­downs or volatil­ity be­cause this could lead you to switch funds at ex­actly the wrong time, miss­ing the re­cov­ery in an un­der­val­ued fund, and in­vest­ing in an over­val­ued fund just in time to ex­pe­ri­ence a draw­down.

Bos­man says miss­ing your in­vest­ment tar­get even by a small amount can have big implications — a 2% un­der­per­for­mance of your in­vest­ments can lead to 30% less re­tire­ment cap­i­tal over a 35-year term. In­vest­ment mis­takes are com­pounded over time, he ex­plains. A loss of 25% in one year will re­quire a gain of 33% to put you in the po­si­tion you were in prior to the loss, and a 50% loss will re­quire a 100% re­turn to make up your loss.

He dis­tin­guishes be­tween the risks of tem­po­rary and per­ma­nent in­vest­ment mis­takes. A tem­po­rary mis­take is when the price of a share drops from fair or be­low fair value to a deeper dis­count to its fair price. Such mis­takes tend to re­verse when the mar­kets calm down, Bos­man says. In this case your port­fo­lio may have a bad quar­ter or a bad year, as the shares you choose for your port­fo­lio suf­fer only a tem­po­rary loss un­til the share price bounces back.

Your in­vest­ments are un­likely to re­cover from per­ma­nent mis­takes, how­ever. These oc­cur when you choose shares for a port­fo­lio on the wrong valu­a­tion (price rel­a­tive to earn­ings). For ex­am­ple, if you had bought Mi­crosoft shares at the height of the dot­com bub­ble in 1999 at a p:e mul­ti­ple of 70, you would have had to wait 16 years for the share price to re­cover, Bos­man says.

Another mis­take that can lead to per­ma­nent loss is choos­ing a share based on the com­pany’s cur­rent cash flow with­out con­sid­er­ing the struc­tural and com­pet­i­tive fac­tors in the in­dus­try, he says. Ko­dak, for ex­am­ple, was a prof­itable com­pany with the lion’s share of the film and cam­era mar­ket in the US. De­spite pro­duc­ing an in­stant-pic­ture cam­era, it failed to keep up with tech­nol­ogy changes and filed for bank­ruptcy in 2011 af­ter its share price fell to a few cents.

Avoid­ing per­ma­nent losses also means avoid­ing com­pa­nies with too much debt, mak­ing them in­ca­pable of weath­er­ing eco­nomic or in­dus­try-spe­cific down­turns, Bos­man says. Fi­nally, if you value a com­pany based on fi­nan­cials that turn out not to be what you thought they were, such as Stein­hoff’s, you could be mak­ing a big mis­take, he says. Cu­mu­la­tive per­ma­nent mis­takes are detri­men­tal to the long-term per­for­mance of your in­vest­ment port­fo­lio, but these can be min­imised if your fund man­ager has a good in­vest­ment process.

Arthur Karas, co-man­ager of the Old Mu­tual Edge 28 Fund at Old Mu­tual In­vest­ment Group, says you should not as­sume that any eq­uity port­fo­lio that de­vi­ates greatly from the in­dex in­creases its un­der­ly­ing risk. By de­vi­at­ing from a spe­cific in­dex, a port­fo­lio man­ager takes a more ac­tive po­si­tion and in­creases its ca­pac­ity to gen­er­ate ex­cess re­turns. There is also the risk of un­der­per­for­mance rel­a­tive to that in­dex.

But Karas says hug­ging an in­dex too closely when the bench­mark in­dex is highly con­cen­trated, as it is in South Africa, can re­sult in con­cen­tra­tion risk that some man­agers find un­ac­cept­able. The 10 largest shares in the FTSE/JSE Top 40 make up about 66% of the in­dex’s to­tal mar­ket cap­i­tal­i­sa­tion, while Naspers makes up a lit­tle over 15% of to­tal mar­ket cap of the JSE over­all and more than 20% of the Top 40 and Swix in­dices.

He says while an in­dex gives you an idea of how a fund man­ager has per­formed rel­a­tive to their op­por­tu­nity set, it is a poor in­di­ca­tor of how much risk has been taken to achieve that re­turn. Ac­tive fund man­agers need to be con­fi­dent enough to step away from the in­dex when their re­search tells them to, and in­vestors need to give man­agers room to un­der­per­form for pe­ri­ods in or­der to re­alise the value of their in­vest­ment choices.

If risk is un­der­es­ti­mated, the ups and downs may be too much to bear Rob Formby

Chief op­er­at­ing of­fi­cer-des­ig­nate at Al­lan Gray

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