How cautious is your cautious portfolio really?

It is a well-known fact that investors’ emotions are mainly driven by greed and fear. As long as markets continue to move upwards, greed has a tendency to run even faster than the market itself, and many investors forget that they may have moved outside of their risk profiles in the process. Only once the market pulls back strongly, like it did these past few months, do investors realise that they may have acted outside of their personal risk profiles. For many it is often too late to act in a corrective manner and they are forced to face the storm head-on until it passes.

It all starts with determining what exactly classifies an investor as cautious, or more specifically, moderately conservative. A cautious investor’s main goal is capital protection, but they are also aware of the fact that short-term investment risks may have to be taken in order to achieve good long-term real returns. The portfolio consists primarily of income-orientated asset classes (such as cash, bonds and properties), but it may also contain a significant number of shares (with higher volatility) from time to time (between 30% and 40% of the total portfolio composition). Cautious investors may need access to their investment funds in as little as three years.

Two main issues arose recently: investors became so overwhelmed by impressive historical returns that they invested capital that should never have been exposed to higher risk investments like shares. Secondly, investors who acted within their cautious risk profiles never adjusted portfolio levels (rebalanced) after the share portion of their portfolios increased so significantly that it no longer fell within their risk profiles.

Rebalancing is an extremely important part of managing a personal investment portfolio and can be done in one of three ways:

1.     Rebalance periodically by doing a proper analysis of your portfolio at least once a year in order to determine whether your different asset classes still fall within your specific risk profile.

2.     Rebalance after a specific threshold or asset weight has been achieved by bringing asset levels down to your original weighting. By using a cautious investor as an example, the investor may want to adjust once their exposure to shares has increased to more than 40% of the total portfolio value by decreasing this asset class back to its initial level of 30% of the total portfolio value. 

3.     Rebalance after a specific threshold or asset weight has been achieved, and then stick to that new limit. A cautious investor in this instance, for example, would like to adjust their portfolio once the exposure to shares has increased to more than 40% of the total value by sticking to a 40% allocation as the new exposure percentage. They will then rebalance regularly to stick to this 40% allocation.

If an individual had invested their capital in the FTSE/JSE All Share Index at the beginning of 2000, the investment would have grown at an annual rate of 14.6%. A cautious investor would have invested only around 30% of the total capital in shares, while investing the remaining 70% in, for example, the All Bond Index, which would have meant that by March 2006 the portfolio’s exposure to shares would have increased to more than 40% of the total value. If the investor had rebalanced by lowering their exposure to shares to its original 30% allocation, and had done so every single time it reached levels of above 40%, the total portfolio would have grown by 14.2% annually over this 16-year period to date. This reminds me of the story of the tortoise and the hare that raced for the finish line – nearly the same amount of growth without the sleepless nights.

Always be cautious and ensure that you remain within your personal risk profile. If you have fallen outside of these levels, rebalance and monitor your personal portfolio on a regular basis, because your wealth is of more importance to you than it is to anyone else.

Schalk Louw  is a portfolio manager at PSG Wealth.

This article originally appeared in the 17 November edition of finweek. Buy and download the magazine here.