HOW TO DEAL WITH RISK IN YOUR PORTFOLIO

Annualised real (after-inflation) returns over five-year periods range between minus 14 percent and 31 percent, but over 20 years, the annualised real returns are always positive. They vary between two and 13 percent.

◆ Check how diversified your portfolio is. If you can’t stomach the risk you need to take, you will have to lower your sights and take less risk for a lower return. A little diversification - across asset classes and across regions - can give you more stable returns without detracting too much from the returns you can earn.

Old Mutual’s Long Term Perspectives shows that a simple 50:50 blend of South African equities and bonds reduces by more than 26 percent the maximum amount by which your portfolio may go down when the markets plummet.

◆ Invest with a manager who considers “downside risk”. Shaun Duddy, a business analyst at Allan Gray, says in the company’s latest quarterly newsletter that equity fund managers take on different levels of risk depending on the shares in which they choose to invest.

Duddy says managers can limit their participation in a market’s negative performance by taking different positions relative to the market and focusing on undervalued shares.

However, Duddy notes that there is no free lunch and that providing this protection can mean sacrificing some upside when markets perform well.

The benefits of this sacrifice are clear to see in times when the market falls, but even during bull markets there tend to be a significant number of “down” periods, making sacrificing some positive return in pursuit of capital protection a worthwhile investment strategy over the long term.

Duddy says when the performance of Allan Gray’s multi-asset Balanced Fund since inception is compared to that of the FTSE/JSE All Share Index, or Alsi (equities only), it shows that, over the 115 months the equity market was up, the Balanced Fund’s average monthly return was 2.7 percent, while the Alsi’s return was 4.5 percent. For the 74 months the market was down, the Balanced Fund lost, on average, only 0.5 percent, while the Alsi lost 3.4 percent.

Although this conservative approach can cost you over shorter terms it can pay off over longer terms. Over 15 years to the end of June, the Allan Gray Balanced Fund has an annualised return of 17.9 percent relative to the 17.12 percent delivered by the Alsi.

Malcolm Holmes, the head of portfolio management at Stanlib Multi-Manager, says Allan Gray has a particular style of investing, but you can also consider diversifying across managers with different investment styles to reduce investment risk.

He refers to Allan Gray’s style as a low-beta one, which reduces its sensitivity to the daily movements in markets, particularly downward ones.

A good multi-manager, who can blend a variety of skilful managers with different styles, can also deliver better returns than the market over time, with less of the downside when markets go through significant sell-offs, such as those experienced recently.

◆ Consider absolute return and derivative protection. Some unit trust funds are what are known as absolute return funds, which target a particular return over a period, such as three years, and also aim to avoid losses over certain periods, such as a year.

These targets may not always be met, but a good manager with an absolute-return focus may be worth considering if you have a shorter investment horizon.

Some managers use financial instruments known as derivatives to protect portfolios from downside risk. Remember that buying such protection comes at a price, which mutes returns.