Reassessing Risk
The high risk of being overexposed to "low-risk" investments
Risk, as it pertains to investments, is difficult to quantify and often professional and retail investors get stuck in measuring risk as a function of a single variable, volatility.
Volatility refers to the quantum of movements in the capital value of a specific investment. At the bottom-end of the spectrum in terms of traditional asset classes is cash or cash instruments. With cash or cash instruments, like money market funds and traditional deposits, the risk of capital loss at any given point is extremely low. The return profile is smooth and there is almost certainty that the profile will be consistently upward sloping. At the top-end of the spectrum is equities or stocks. Equity values change daily, and the moves can be up or down, meaning that your return profile often looks raggedy and at times you can even be in a loss-making position.
The problem with only looking at volatility as a measure of risk is that you miss all the other risks that could see your longer-term performance suffer and see you in a worse off position, unable to fund your investment goals, particularly when accounting for factors like inflation, taxes, and the rand exchange rate.
Inflation
Inflation erodes the value of your money over time. If you consider cash investments for example, a high interest rate may look attractive when considered in isolation but when factoring in the SARB's mandate (keeping inflation under control) - a high interest rate usually coincides with high levels of inflation. This means that a current annual money market rate of 7.75% looks much less attractive when considered in real or "after inflation" terms. Headline inflation was 7.1% in March, this means you will be receiving just 0.65% after inflation. Longer term, the story is very similar.
Over the last 10 years you would have received an average 6.2% versus inflation during this period of 5.1% on average - giving you a real return of 1.1%. Compare this to the equity market during this time. The JSE All Share Index delivered a total return of 10.5% per annum - giving you a real return of 5.4% per year.
Taxes
Taxes, particularly for individuals, must factor into one's decision when investing in different asset classes. Remember, interest is taxed at your marginal tax rate, while dividends and capital gains are taxed at 20% and 18%, respectively.
The Exchange Rate
The rand is what we refer to as a "structurally weakening" currency. The reasons for this include that our interest rates and inflation is higher than those of the major economies. It is important to think about your returns in "hard currency" terms as well. If you are planning to fund a large liability overseas (be it a once in a lifetime trip around the world) or to retire aboard, you need to factor in a depreciating currency by considering investments offshore or in locally listed rand hedge stocks.
What do we do to make sure that we are taking the appropriate "risk"?
1) Be aware of your investment goals (liabilities) and time-horizons. If your goal is retirement and you still have a long way to go before you will require an income from your investments, it is particularly important and suitable to take on additional risk. If you are saving for school fees due at the start of next year, it may not be appropriate for you to invest those funds in the equity market. If you want to fund an overseas holiday or plan to retire abroad, you will have to think very carefully about how the exchange rate factors into your goals.
2) Diversify. Having all your money in one specific asset class/instrument can negatively influence your overall investment experience. You still want to be shielded from volatility somewhat, which means that you cannot only be exposed to equities. Having a portion of your investments in fixed income or cash instruments will help smooth out your return profile. On the flipside, having more "risky" investments in your portfolio will help you achieve better returns over time - shielding your investments from inflation and providing better after-tax returns. Finally, adding some offshore or "rand hedge" exposure to your portfolio will help guard you against a depreciating rand.
3) Seek financial advice if you are unsure. A professional advisor can help you make the right decision for your specific set of circumstances.
