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25 Jan 2008 14:30
Six months ago, everything was rosy—robust global growth fuelled by seemingly limitless demand from China and India, strong corporate balance sheets, record prices across most asset classes, and enormous infrastructure spend anticipated in South Africa.
In the pursuit of growth, risk was ignored and bad news was promptly swept under the carpet.
Fast forward to today—despair as most markets enter bear territory (having fallen more than 20%), the subprime contagion sweeps from the United States to the United Kingdom, Europe and the East, spiralling commodity prices threaten inflation targets, and in South Africa our possible future president faces criminal charges and load-shedding is commonplace.
Appetite for risk has disappeared and any bad news stokes further panic.
Some of the facts have changed, but emotion (as reflected by market moves), has been more volatile than the facts.
What should investors do? Is it time to sell and avoid further losses, an opportunity to pick up stocks at bargain levels, or time to do nothing?
Sensational headlines make it very difficult to remain unemotional.
Return and risk are joined at the hip
Investors have had it too good for too long. Over the past five years, risky asset classes (equities, property, private equity, emerging markets) have all provided stellar returns with very few hiccups. Investors have come to expect this as the norm—20% returns with single-figure volatility. This is abnormal. Volatility is normal, and an unfortunate reality of seeking solid returns.
Realistic expectations and correct measurement periods
To put this in perspective, the JSE has returned inflation plus 24% a year over the past five years. History and common sense, since companies’ earnings are linked to the real economy, teach us to expect returns of inflation plus 8% (before costs) from equities over the long term. Returns from risky assets are lumpy and do not occur in a straight line. It is, therefore, important to assess portfolio performance over the appropriate timeframes.
We believe the minimum period to measure (and develop expectations of) risky assets is over the full business cycle. Accordingly, for equities an appropriate period would be about seven years, for a balanced fund five years and for lower-risk funds three years.
Why not just time the market?
It is extremely tempting to try to sell before the market falls and to buy again before the next period of appreciation. Such a strategy would be enormously profitable and reduce much of the angst. Unfortunately very few managers are able to do this successfully.
Research has shown how few get this right, and those who do require steely resolve and much patience. The record of individuals is even worse—a good indicator of this is mutual fund flows, which consistently follow last year’s best performers. The long-term impact of such behaviour is devastating to investor’s returns.
This is true across regions and time periods. A comprehensive study done by the University of Michigan concluded that dollar-weighted returns (the experience of the client) were consistently lower than the time-weighted returns (actual performance of the fund) over a range of markets and periods.
Over an 80-year period in the US, investors received 1,3% less a year because they went in and out of funds at the wrong time. The experience with higher-risk markets (such as the Nasdaq) is significantly worse, at 5,3% a year. The study also shows that as the investor holding period has reduced over time, so the deficit has increased.
Significant market declines are relatively commonplace
In the heat of the moment, it is easy to forget that relatively meaningful market declines happen quite regularly. Since 1960 the South African stock market has fallen by 30% or more seven times. The reasons have varied from the Gulf crisis and wars to emerging-market woes and the unwinding of various bubbles. Each time, the short-term outlook has appeared dire and many investors have panicked.
In all these cases stock prices have recovered. The length of time to recover has varied from 19 to 59 months. Furthermore, research conducted by Nedgroup Investments shows that if one looks at the South African equity-market total returns over monthly intervals of rolling five-year periods since 1961, not one of the 493 such periods was negative.
The duration of the drawdown (time to recovery) depends on a range of factors. One of the most important factors is how expensive the assets were prior to the setback. Where assets are very expensive or overvalued (for example the Nasdaq in 2000), there is a risk of permanent erosion of capital. Our broad view is that developed-market assets are starting to look attractive and we favour South African equities and cash over property and bonds.
If these are the lessons that history has taught us, how should investors react? The answer is to go back to basics.
The starting point should always be a thorough understanding of the reason for investing. For those looking for growth over the long term, a reasonable allocation to equities remains appropriate. It makes sense to diversify a portion of one’s assets offshore and investors need to be more realistic in terms of their expectations of both risk and return.
Although the temptation to try to time the market is significant, history teaches us that this is very difficult to get right.
A more relevant approach is to develop a sensible investment strategy based on clear objectives and then stick to it. Human emotion is the biggest destroyer of value. Do not let it get the better of you. Very often the best thing to do in volatile markets is to remain level-headed and do nothing. We should only change our investment strategy when our objectives or our personal circumstances change, not when investment markets go up or down.
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