Investing: low risk, high return
GAMBLE: MUST HAVE STOMACH FOR BAD TIMES
A lesson on impact of making emotional decision during periods of market turmoil.
Over the past 25 years, the JSE has been through three major downturns. There was the emerging markets crisis in the late 1990s, the dotcom crash in the early 2000s, and the financial crisis that hit in 2008.
Despite these setbacks, the FTSE/JSE All Share Index (Alsi) delivered an annualised return of 13.6% between January 1996 and November 2019.
At an average inflation rate of 5.8%, this means that investors have earned real returns of 7.7% per year.
This is an outstanding outcome for long-term investors. However, it’s likely that not everyone earned it, because to do so you had to have the stomach to sit out these events.
From peak to trough in 1998, the Alsi fell 43.8%; between March 2002 and April 2003 it dropped 36.8%; and in 2008, it took just six months for the index to lose 46.4%.
The scale of these crashes would have scared many investors out of the market. They would have seen their investments rapidly losing value and withdrawn them to save themselves further pain.
While this would have given them some short-term comfort, it’s worth appreciating the long-term impact of these kinds of decisions.
“Using recent past performance as a proxy for future investment returns appears entirely reasonable,” says the head of research at PSG Asset Management, Kevin Cousins.
“However, at crucial points in the market cycle – typically when valuations are at extremes – basing investment decisions on recent historical returns can lead to very poor outcomes.”
To illustrate this point, PSG looked at what would have happened to the value of an investor’s money if they had withdrawn it after each of the three market crashes since 1996, and only re-entered the market a year or two later. The results are illustrated in the graph.
An investor who stayed out of the market for one year after each crash before putting their money back in would have seen a real return of only 2.7% over the full period. In nominal terms, they would have a little more than a third of the money they would have had if they had stayed invested throughout.
Someone who withdrew their money and kept it out of the market for two years on each occasion would only have earned just more than inflation.
Their total would be less than a fifth of what they could have had by leaving their money where it was.
“While this is a stylised example – we have not included interest earned while out of the market and did not deduct any fees or transaction costs – it clearly illustrates the impact that making an emotional decision during periods of market turmoil could have,” Cousins points out.
While this focuses on major market downturns, investors should think about the wider lesson as well.
Historically, over any rolling five-year period, the JSE has never delivered a negative return.
Over any rolling 10-year period, it has failed to deliver an above-inflation return only 5% of the time.
This shows that the risk of losing money for a long-term investor in equities is low.
The potential gains from staying invested, on the other hand, are high. Over the past 90 years, the market has produced an annualised return of 13.8% per year. That is double what has been available from cash.
It illustrates impact of an emotional decision.