Just how much risk are you taking?

I met with a new client recently who proudly proclaimed that she was a “low risk investor” while passing me her unit trust statement. She has R1.1 million in a money market unit trust fund and it has been there for a few years.

While this might have been a good thing (from one perspective) over the past 2 years, I pointed out to her that while she was in “low volatility” portfolio, she had actually turned herself into a high risk investor without even realizing it. She may have taken the “roller-coaster” effect out of play but in doing so she has exposed herself to at least 3 other (probably greater) risks. They are:

• Income tax: she may have earned ±R110000 interest on this amount, the first R19000 of which interest is tax free, but she will lose ±R32000* to tax. This will reduce her yield from ±10% to about 7% (which is below inflation).
• Interest rates: in the past year alone, rates have declined significantly and cash yields are now below inflation.
• Inflation risk: this is the greatest area of concern and while she may currently sleep well at night, the real value of her capital is decreasing on an annual basis and will probably never grow at a rate that is greater than inflation (see table below).

Investing is about probability and not prophecy. We don’t know which sector will perform best next nor do we know when the rand will weaken further or even if the market has bottomed. We do know, however, on balance of probability (built up over a very long time) that as an asset class, equities will outperform property which will in turn outperform bonds which will outperform cash (after tax). This is a fundamental consequence of the risk/return relationship. Statistics show that SA asset classes have produced the following real returns over time:

Asset class              Real return          Volatility

Cash                          1.9%                         1.3%
Bonds                        2.1%                         7.2%
Property                     7.6%                        19.7%
Equities                      7.6%                        22.3%

Source: Prudential Asset Management: 1966-2008, property since 1977

What investors (and advisors) don’t realize is that:

1. You can’t consistently pick the winners (you’d be better off buying the losers),
2. You can’t repeatedly time the markets (no matter how good you think you are) and c) If you want to accept cash returns as your worst case scenario, then you also have to accept cash returns as your best case scenario.

We need to remember then, that volatility is a function of the risk/return relationship! There are periods (which can extend for a number of years) when the equity markets can be extremely volatile – the way to combat this is to have a well diversified portfolio with sufficient access to cash (short term funds) so as to allow you to ignore the ups and downs in the short term (from a financial planning point of view this should be ±6 months income need).

It is the role of the financial planner to coach their clients to stick to their plans and be patient. What they need to realize is that markets are designed to transfer wealth – often it is simply from the impatient to the patient! The secret to accumulating wealth over time is to have a diversified portfolio (across all the asset classes) and to buy low and sell high. To do this you have to be patient! Remember you are an investor and not a speculator.

“The psychology of the speculator mitigates strongly against his success. For by relation of cause and effect he is most optimistic when prices are highest and most despondent when they are at the bottom.” (Benjamin Graham, Security Analysis 1934)

*this assumes a tax rate of 30%

Related posts:

1. Just because it is raining it does not mean the drought is over!
2. Financial Planning for Dummies – Part 3
3. It's not all in the name
4. Anyone seen the fat lady?
5. The great equity debate continues