Tag Archives: volatilty

Cash guarantees?

We have come across many clients recently who are wanting to move their funds into the “bank” following the very poor returns of the past 5 years. Their rationale usually revolves around the fact that at least they would be guaranteed a return of ±7% per annum compared to the dismal returns from the market.

What we have to keep reminding them is that yes, they may well get a “guaranteed return” in the short term, but we can also guarantee them that they will be poorer in the future if they follow this route. Money markets are great for short term use – they are not appropriate for long-term investing. As someone once said to me “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”

Perhaps it is pertinent to remind ourselves about a few good old investment principles:

  • Markets move in cycles: they go up and down over time (not necessarily in that order).
  • Nobody knows exactly when this will happen – no one can consistently time the markets.
  • Equity markets (shares) should provide out-performance over the longer term (>10 years) but they are also more volatile over shorter periods.
  • High risk does not necessarily imply a high return (take gambling for instance).
  • Diversification is the prudent way to manage risk. This includes diversification among various asset classes, regions and investment styles.
  • Be mindful of the costs associated with your portfolio – higher costs will generally lead to lower returns over time.

Now is NOT the time to be deviating from your investment plan (unless your personal circumstances have changed). 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. In fact, statistics show that SA asset classes have produced the following real returns over time:

Asset class Real return
Cash 0-1%
Bonds 1-3%
Property 2-4%
Equities 7-9%

  Source: Fortune Strategy, Bradley et al (the international experience is similar)

What investors fail to realize is that with the risk/return relationship comes volatility! 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. “The psychology of the speculator militates 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.” Remember you are an investor and not a speculator.

It was Warren Buffett who said “Be fearful when others are greedy and greedy when others are fearful”. When people start to get greedy then it is time to be fearful and vice versa. From what I am seeing around me, there is too much fear – maybe, just maybe, it is time to start “getting greedy”.

Risk free returns?

I recently saw an advert for RSA Retail Bonds that was advertising “risk-free” returns. This kind of thing really gets up my nose and in my opinion it smacks of false advertising…RSA Retail Bonds are not the only culprits – just about all of the banks do it too.  “No fees or commissions” or “Risk-free”.

Let’s get this straight – there is no such thing as a risk-free investment. The reason they are advertised as “risk-free” is because they are only ever referring to one kind of risk; that of volatility! These “investments” never refer to inflation risk and they also assume that “default” risk could never apply either!

Broadly speaking there are 2 kinds of risk that really matter to investors: volatility and inflation and they are kind of on the opposite ends of the risk spectrum from one another. Volatility is a short-term risk whereas inflation is a long-term risk.

When things like RSA Retail Bonds claim to have no risk associated with them they are referring to volatility and that is all. They are not claiming to be risk-free, especially when it comes to inflation risk. This is, in my opinion, misleading. You could well invest your money into these kind of investments believing that you are taking no risk at all (because that is what the adverts imply) and then find out that when your investment falls due that you actually have less money (in real terms) than when you started off – all because you did not take enough risk. It’s kind of ironic that in order to counter inflation risk you need to take some volatility risk.

On top of this, any money invested into the RSA bonds is locked in for a minimum of 2 years. The historic returns from these investments have been around 7% pa. By contrast, if you had invested into an “enhanced income” type unit trust fund you would have had returns of ±8-10%* pa for the past few years and would have had access to all of your capital within 48 hours…and all because you took a little bit of (volatility) risk!

So be warned; RSA Retail Bonds are not “risk free” as is claimed. They carry a significant amount of inflation risk, especially after tax.

 

Note:

*typically these funds are designed to generate returns of “cash+2%”pa. This is not guaranteed and there is a small amount of volatility risk that could apply over periods of less than 12 months.