October 10 2007
By Henry van Deventer
Over the last few months, our local equity market has had a bumpy ride. As a result, a number of investors have been sitting on the sidelines waiting for things to ‘settle down’ before taking the plunge. But is this strategy in your best interest?
In a way, investments are like buying a good pair of shoes. We all know and understand why, in the long run, a good pair will be better than a cheap pair. We also expect to pay more for the good pair. This is why a shoe sale creates so much excitement — it’s an opportunity to buy something of good quality at a low price.
In investment markets, as in buying shoes, we expect to pay more for quality investments. The problem is that it is somewhat harder to easily tell a good investment from a bad one and we therefore rely much more heavily on price as a guideline. Therefore, when the share market is highly valued, we tend to get excited and invest, but when the 'sale' starts, we choose to stay away.
The best investment
When prices fall, it's easy to forget that shares are the best investment in the long run, having outperformed inflation by roughly eight percent every year for the last 20 years. When prices fall, we are therefore presented with an opportunity to buy quality shares for less. If, however, prices do not fall, we still need to decide whether it is necessary to invest in the share market anyway in order to achieve our longer-term investment goals.
In times of uncertainty, our gut reaction is to take to the mountains until the storm has passed. This still leaves us with the very tough decision of knowing when the time is right to return. The interesting thing is that the share market, on average, gives us a negative return once every three years. This means that if we choose to wait for prices to keep falling before we invest, we will be wrong most of the time. So if the odds are stacked against fleeing, how can we fight this urge? The most important weapon we have is diversification.
As a rule, we should be making our investment decisions based on choosing the most appropriate way to achieve our targeted return so that our money can give us what we need. Once we know what our target return is, we can either bet on one asset class (such as equities) to achieve this return for us, or we can combine different asset classes (mainly equities, property, cash and bonds) to ensure that we are protected if any one of these goes through a volatile phase.
A diversified strategy has significant benefits. If we look at the last ten years, equities have given us an average annual return of 18.91 percent at a level of volatility (risk) of 21.92 percent.
If, however, you were to invest in a typical balanced portfolio (60 percent equities, 30 percent bonds and 10 percent cash), your annual return would have been approximately 17.42 percent, but your level of volatility would have fallen to 14.51 percent — roughly a third less ‘risk’ than a pure equity investment. So if you needed a return of only 12 to 14 percent, why would you want to carry the burden of so much extra risk?
Once we choose to diversify, short-term market movements become much less pronounced and our emotional reactions reduce accordingly. Where many of us fall down is in our failure to realise that if we have suitably diversified portfolios, we already enjoy this protection. We instinctively rather look towards the uncertainty of a specific asset class instead of how our portfolio as a whole is tracking towards where we need to be. By unlearning this behaviour we empower ourselves to make the right investment decisions for the right reasons and, most importantly, to stick to them.
The purpose of investing is to achieve a positive return and to meet our investment objectives. As investors, we should therefore always choose an investment strategy that maximises our expected return — and our chances of achieving it — over our chosen investment term.
For the vast majority of investors, this should involve remaining invested in the market for as long as possible and systematically building a positive return over time, enjoying the upward trend that equity markets give us. We must remember that a consequence of this ‘buy and hold’ strategy is that we need to be prepared to absorb the impact of all the bad days. Despite these bad days, equities still tend to deliver positive returns in most years, over most periods in the medium term, and almost all periods in the long term.
In a suitably diversified portfolio, the impact of short-term volatility in one asset class (such as equities at present) will have a watered-down effect. This impact is further cushioned by the fact that an asset allocation management focus will tend to take positions that will further protect you from possible losses when markets are looking expensive. Warren Buffett once said that it is only when the tide goes out that we see who has been swimming naked. This is the time for us to best appreciate the swimming trunks a responsible investment strategy offers.
Henry van Deventer is the acsis financial planning coach.