There are a few ways to reduce short-term risk in a portfolio and not all of these require a matching dilution in long-term returns.
Pay less than its worth
The first way is to try to buy assets for less than their fundamental value. Any estimate of fundamental value needs to forecast the future profitability and growth of a company and is thus inherently inaccurate, so it’s useful to include a margin of safety in your estimates to protect against nasty surprises.
A stock market works so that the best potential returns are on offer from investments that find it hardest to attract capital.
Theoretically, these should also be the investments that are most risky. In practice, this is not always the case, allowing an investor with the time and skill to make independent estimates of fundamental value, and the strength of conviction to own unfashionable shares, the opportunity to achieve a higher return and a lower risk of capital loss.
Our overweight position in Japan is a good example. After two decades of decline, the shares of many Japanese companies have for some time been on offer at prices that the Orbis and Allan Gray investment teams find attractive. The tragic recent events were a reminder of how much short-term impact the unpredictable natural world can have on market sentiment, even when that sentiment was depressed to begin with.
While the Japanese earthquake and tsunami affected Allan Gray’s clients’ portfolios, the impact was limited because the Japanese shares in these portfolios were already well priced. Thus, despite a 20% drop in the days following the disaster, the Topix recovered quickly to November 2010 levels, 10% off its recent highs. Some outcomes in Japan are still unfolding, but Orbis’ judgement has been that even this price decline has been much greater than its current estimates of the impact on the economics of businesses in the portfolio.
Diversification of asset classes
Another way to reduce risk is by diversifying. If you invest in two individual shares your investment is less risky if they tend not to underperform at the same time. If you add more investments that perform well at different times it is possible to reduce risk substantially without reducing returns.
Hedging your bets
Buying insurance, or hedging, against stock market declines is a third way to reduce risk. Since the financial crisis the rand has tended to strengthen and weaken at the same time as global stocks, both being driven by the appetite for risk and return from global investors.
As a result, some of the upside you would expect to gain from potential rand weakness by investing in offshore shares is lost as losses in the shares cancel out gains from a weaker rand. Despite low interest yields this can make foreign cash, or a hedged investment, a worthwhile addition to diversified portfolios.
Finally, an investor can reduce short-term risk of loss by holding cash. This is not only a mechanism for reducing risk; cash also allows an investor to take advantage of future investment opportunities.
Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information.