By most measures, a number of equity markets, including South Africa are looking stretched in value. As Investors, we have had a relatively smooth ride, with very generous returns since 2009. These above average returns are unlikely to continue for another 6 years, but we cannot know precisely what will happen to change them nor how. One common expectation the asset managers that we engage with regularly, have, is the expectation of volatility over the next 12 months. There are a number of sources of risk in these strange times, the obvious ones being the Greek debacle, Chinese asset bubbles, slow Chinese growth, the expected upward moves in interest rates this year (or will it be next year), to name a few.

With this backdrop, investors are more tentative than usual, especially when it comes to investing new money. Should you put your money to work in an equity fund knowing that you could be 25% down if a steep correction followed shortly thereafter? On the other hand, would you prefer to invest in an income fund, safe in the knowledge that you will be brave enough to invest this precious sum into a sea of uncertainty and volatility when (and if) markets do correct as expected?

Both approaches mean facing significant uncertainty at some point in the future, but a sound strategy and strong financial advisor will ensure that you stick to the plan when you eventually do face uncertain times.

So in the event you had new money to invest, how should you approach the question of what investment strategy to follow?

The answer to that is contained in the answer to the question: “how much volatility are you prepared to stomach over any 12 month period?” I use the word “volatility” deliberately as volatility refers to a temporary dip in the value of a portfolio. (A permanent dip is a permanent capital loss, an entirely different topic). Can you tolerate (i) no dip, (ii) a 5% dip, (iii) a 10% dip or (iv) a 20% dip? Bear in mind that at the time the dip feels like a permanent capital loss, but with the right investments, 
it won’t be.

Remember that as long as history repeats itself and your investments are sound, weathering the dip eventually comes with a reward. This is because the asset class with the highest volatility, delivers the highest return in the long run. But there are two unknowns about the dip: how deep will it be and for how long. And for this reason, depending on your personal circumstances and preferences you may want more volatility, or you may want less.

For those who think better in pictures, the following graphically shows the above point by using four funds from the same asset manager, Coronation Asset Management. Each fund has more equity in it than the previous fund (which implies more volatility). In layman’s terms, the funds range from the most conservative, Income Fund, to the more aggressive, Equity Fund.

Investment Growth

This graphically shows the relationship between volatility and return. If you prefer less volatility, you must expect less return. The Income Fund has only ever lost a maximum of 0.62% since 1 Jan 2008. The equity fund however has lost a maximum of 26.85% during the same period. However over the whole period the equity fund returned 16.01% and the Income fund returned 9.89%. If you want more return (Equity Fund), you must expect more volatility. and more volatility means more uncertainty. And more uncertainty at some point will mean more discomfort, regret and phone calls to you financial advisor.

Understanding this relationship and then quantifying it for yourself, is the starting point for a detailed discussion about your appetite for risk, and how to go about structuring an investment that works for you.

Compiled by
Mike Moore, Wealth Manager
WellsFaber (Pty) Ltd