Traditionally, investing means exposing your money to one or a combination of the following traditional asset classes, to generate inflation beating returns:

  • Equities
  • Property
  • Bonds
  • Cash

However, this objective must be balanced with your appetite for uncertainty. In the investment world, uncertainty comes in the form of volatility – the amount by which the value of your investment goes up or down relative to its long-term average return. The greater the return you seek, the greater the volatility you will be exposed to.

Historically, the asset class that has generated the highest return per annum, has been equity. The following table shows the annualised returns of South African equities, bonds and cash since records began in 1925. We have included property in the table to demonstrate where it positioned on the scale of expected returns, although records for listed property do not stretch back as far.

SA Enquiry SA Property SA Bond SA Cash
Long Term Historical Return Inflation + 7.3% Inflation + 5% Inflation + 2% Inflation +1%

If you had invested in equities in 1925, this would have been the asset class that delivered the highest return, by far. When you consider the compounding effect, as the chart below shows, after 57 years you would have an investment nearly 36 times greater in value, than had the same amount been invested in cash.

R1 invested in equities in 1960, would be worth R8 824 today, whereas an investment in cash would have resulted in a return of R 246.

However, equities do not deliver returns similar to cash in a bank account, where your interest is predictably credited to your account each month. Equities deliver returns randomly. It is the asset class with the highest volatility – and therein lies the challenge.

If I Invest in Equities, Can I Lose My Capital Permanently?

When you invest in equity, you invest in the share capital of a company, and as such you participate equally in the success and failure of that company. If the company delivers an outstanding performance, you will make outstanding returns. However, if the company goes insolvent, you may well lose your invested capital, as you are the last in line to a claim on the company’s assets. Clearly this sounds highly risky, and if you invested your savings in one company’s equity – it would be!

Investors have learned to manage this risk by investing in the equity of a portfolio of companies, ensuring there is not too much exposure to a single company. A unit trust that invests in equities will typically have investments in around 40 companies, and the largest single exposure will rarely be above 10% of the fund. When Steinhoff collapsed, few of the worst affected general equity funds had exposure above 7.5% to Steinhoff shares. As unpleasant as the experience may have been, investors in these funds may have lost, say 7% of the value of their investment in the portfolio, which although not ideal, is recoverable over time, and not nearly as bad, had they invested 100% of their capital in Steinhoff. In other words, although we speak about equities being risky, there is a negligible risk that you will permanently lose your capital in a portfolio of well diversified equity investments managed by a credible portfolio manager. The value of an equity portfolio is however expected be more volatile than any of the other three traditional asset classes.

Managing Equity Exposure

The amount of equity exposure in your portfolio is fundamentally determined by how much volatility and/or uncertainty you can tolerate. If you need your money to buy a house in two years’ time, then you can tolerate very little volatility and consequently very little equity exposure. However, if you require your money for retirement in 20 years’ time, then in theory, you can tolerate high volatility and high equity exposure.

The Engine for Growth

Equity is the growth engine of a portfolio. If it is long term equity-like returns that you require, then you would require equity exposure, time, patience and discipline to hold out through tough times, when equity markets are not delivering.

If you require short term certainty, you must manage the mixture of equity exposure with the other asset classes to maximise returns within your constraints.

Managing Investor Behavior

Human beings can be their own worst enemies when it comes to investment in equites. When equity markets fall, drift sideways, or underperform for a few years, we can’t resist the urge to switch out of the uncertainty of equity into the seemingly greater certainty of cash, bonds or property, in the expectation of temporarily generating higher short-term returns, and some temporary psychological relief. Unfortunately, this behavior hampers the ability to achieve the long term returns you are targeting. Making sure you have the right equity exposure for your needs and sticking to it, is paramount.

 

Compiled by Mike Moore