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Investment Strategy
Thursday, May 1, 2008
Risk reward

It’s Buffet who says “I’d rather have a lumpy 15% return on capital, than a smooth 12%.” As the world’s best investor he understands the impact of compounding higher numbers and hence has a high risk portfolio. The great paradox with investments and risk perception is that when risk is perceived to be low it’s often high. And vice versa, when the perception of risk is at its highest, investment risk is low.

In a difficult past 12 months where the return on the JSE came in at just 11,1% and where many investors may have received far less than this due to the positioning of their portfolio we tend to hear the words, “I could have achieved a higher return just by sitting in cash, why should I be exposed to the market.”
Comments Ian de Lange of Seed Investments, as returns on cash improved with interest rates climbing and returns on equities declining sharply – depending on where you measure from – many investors have questioned why they are even exposed to risky assets.
“It’s a very good question – why take the risk when you can get the same return for virtually no risk?” he asks.
This is perhaps also especially relevant for banking and other financial shares – putting your capital in the bank would have returned perhaps 10%, but putting your funds in the Financial 15 index would have gone backwards by 17,6%.
It’s a big difference and not something that can be simply brushed aside.
But as we all know hindsight is an exact science.
Says De Lange, “The answer lies in the fact that over time an owner of a riskier asset is compensated for the additional risk. It’s what is known as the equity risk premium. Over time equities have more than adequately compensated owners for the additional risk of being ordinary as opposed to preferential shareholders.”
He says compounding up the additional return over many years it’s not even a race – owners of real assets win hands down. “An investor with R1 000 in 1960 had a choice – invest into fixed deposits and keep reinvesting the interest – i.e. compound the returns. According to JP Morgan’s numbers his final value at the end of 2006 would have been R785 00.
“Had our more astute investor invested into the JSE All Share index his final balance would have been R2,14 million. It’s a BIG difference.”
However, long run numbers mask the pain investors feel over any shorter period. “And by shorter periods I mean two to three years, not two months.
On a rolling five year basis an investment into equities has since 1960 in South Africa at least, not given less than 0% compounded return. The lowest nominal return was 4,8% compounded from 1994 – 1998.
In real terms however of any five year period, equities have occasionally given negative returns. Over the high inflation period of 1973 – 1978 (six years) equities produced a negative real return (i.e. after inflation).
For investors who cannot remain fully invested in the equity market through its ups and downs, there is therefore always going to be a trade-off. That is, to accept slightly lower long term returns for not being fully exposed in order to ensure slightly less volatility.
“We don’t necessarily advocate a full exposure at all times,” says De Lange, “because as history indicates in periods of high inflation and when markets have come off a high base, there may well be an ensuing period of poor returns. At all times, it’s a matter of assessing absolute and relative valuations.”
Clearly an investor such as Buffett can remain fully invested into risk assets, not having to try and make any timing decisions and knowing that a long term investment view will produce a higher end result.

Copyright © Insurance Times and Investments® Vol:21.4 1st May, 2008
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