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The risks in chasing higher returns

Nov 27 2017 12:33
Schalk Louw

The bee has to be one of the most interesting insects around, and seeing one always reminds me of the children’s story of how the bee got his stinger. 

The bee got sick and tired of being confused with a fly and having to dodge fly swatters all the time. 

So he went to Mother Nature and asked her for a weapon as effective as the grasshopper’s hind legs or the spider’s bite. Mother Nature gave Bee one option that came with a massive risk. 

She could give him a stinger that he could use to inflict pain on others, but he would only be able to use it once in his lifetime. 

After using it, he would die. 

Because Bee was fed up with being bullied, he agreed to the terms and from that day onwards, he had a stinger. Even though he could inflict pain, and even cause death with his stinger, he carried the risk that he too would die if he ever used it. 

As investors, we are faced with similar dilemmas on a daily basis. With money market rates currently at around 6.7%, other investment instruments are looking much more attractive. When taking a maximum tax rate of 45% into consideration, investors would have to be satisfied with a mere 3.9% in returns. 

If all variables were to stay the same, investors wouldn’t even be able to keep up with inflation (currently at 5.1%). So we are literally becoming poorer by the day. 

Unfortunately, unlike the bee, we cannot ask for more ammunition. By moving your investment from money market to the slightly riskier bonds, you may (at current interest rates) be able to get a better return of around 9.5% before taxes. 

But the use of this “stinger” may also bring about some indigestion. 

Investment risks

Before we continue, let’s define risk in the investment environment. There is definitely a positive relationship between risk and returns. The standalone risk of an investment is measured by the standard deviation in volatility. 

It shows the historical volatility limits within which the investment moves (statistical assumption of normal distribution).

When studying the stand-alone risk of our five leading investment instruments, it quickly becomes clear that the right choice definitely isn’t an easy one, and that the wrong choice can have even more severe side-effects than a bee sting.

As expected, money market definitely carries the lowest risk, but as I mentioned earlier, it also delivers the lower returns. 

Bonds may offer more value on paper, but with a total investment return (which takes into account interest as well as price movements, or declines in the case of bonds, over the last 12 months ending 20 November 2017) of only 4.9% before taxes, the effects of the recent political uncertainty in South Africa becomes all too clear. 

Even when we take a look at the annual standard deviation over the last two years, 8.2% tends to lean more towards the higher (risk) side. 

Offshore performance 

The weakening of the rand and the strong rally in first world countries’ stocks definitely helped to make offshore investments one of the best-performing investments over the last 12 months. 

A 50/50 investment in the MSCI All Country World Index and Citigroup World Bond Index would have yielded 11.4% in returns (in rand terms) over the same 12-month period. But at a standard deviation of 15% over the last two years in rand terms, it also would have come with the highest volatility. 

Remember Naspers

When we take a look at local shares by only focusing on the FTSE/JSE All Share Index, you would think that it took first place with a whopping 23% returns over the same period. 

Its standard deviation of 11.2% over the last two years could even be considered as relatively low. But it’s only when we remove Naspers from this equation that the bee’s stinger becomes visible. 

Without Naspers, this index would have grown by only 3% over the last 12 months, meaning investors should be very careful not to be swept along by the euphoria surrounding current market conditions. 

As an investor, it is important that you don’t focus on only one asset class when you review your total investment portfolio. 

By properly diversifying your portfolio across different asset classes, you will fight risk in one of the best ways possible, and you won’t end up having to choose between nothing on the one hand, or a stinger that comes with a huge disadvantage on the other.  

Schalk Louw is a portfolio manager at PSG Wealth.

bonds  |  shares  |  risk  |  money market
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