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Investment Strategy
Friday, February 1, 2008
Historical fact

Diversification is a useful tool in enabling investors to grow their wealth in excess of inflation over time. By diversification we mean including asset classes in a portfolio that react differently to prevailing market conditions. By diversifying in such a manner we can expect higher probabilities of beating inflation than would otherwise be achievable.

By reviewing the returns of the major asset classes (local equity, international equity, local bonds and local cash) since 1960, history shows us that diversification has indeed benefited investors. Firstly, let us consider the performance of these asset classes individually. The first table shows the annualised return above inflation and the risk of each of the asset classes over the 47-year period starting in 1960. Risk or volatility is a widely accepted statistical measure of the degree of variation of return. In this example we have not taken costs or tax into consideration.

Source: Nedgroup Investments, 1960-2006


One can immediately see that local equity, while providing the greatest annualised return (8,9% pa above inflation) over the period, also appears to be the riskiest. International equity has produced returns of 7,2% pa above inflation (in rand terms), with slightly less risk than local equities. Local bonds have produced the lowest return over the period (1,8% pa), while local cash has been the least risky asset class. Inflation has been 8,5% pa, on average, over the period.
We are also able to calculate how often the individual asset classes outperformed inflation over various time periods. The next table gives the percentage of periods that each of the asset classes has outperformed inflation. The final column in the table shows the success rate for a typical diversified portfolio consisting of 60% local equity, 15% international equity, 15% local bonds, and 10% local cash that has been re-balanced monthly.

From this one can see that over any one-year holding period, local equity has a 67% chance of outperforming inflation, while over any 10-year holding period this increases to 95%.

Some very clear trends emerge from the data. The higher risk asset classes (local and international equity) offer a greater chance of producing inflation-beating returns than lower risk asset classes (bonds and cash), except over one-year periods. In terms of what investors’ true objectives are, it therefore appears that the existing definition of risk is misleading, as the asset classes that are conventionally understood to be the ‘riskiest’ actually have the highest probability of outperforming inflation over all but at the shortest periods.
As the investor’s time horizon increases, higher risk asset classes have a significantly improved chance of beating inflation, while lower risk classes are in a worse position.
For all periods greater than one year the chance that the diversified portfolio outperforms inflation is at least equal to, or better, than the chance that any individual asset class will beat inflation. This means that one can use assets that individually have lower probabilities of beating inflation to construct a portfolio that has superior inflation-beating characteristics. This is diversification at work.

Copyright © Insurance Times and Investments® Vol:21.1 1st February, 2008
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