Citadel Director and Durban Regional Head Nic Horn crunches the numbers to show why risk management should always be the first consideration in investing, and demonstrates the benefits of true diversification for building wealth.
In March, the COVID-19 crisis saw one of the quickest and deepest sell-offs in stock market history, with some South African equity portfolios losing nearly a third of their value within the space of a few weeks. However, while this sell-off has created a number of bargain-buying opportunities, investors need to be extremely cautious of indiscriminately rushing into equity markets on the assumption that what goes down will automatically come back up.
Instead, simple mathematics demonstrates that risk management should always be the first consideration in investing, as the benefits of limiting your potential investment losses can far outweigh the gains of market upswings in building your wealth. The reason for this is the asymmetry of risk, or the fact that after suffering a loss, your investment has to claw back even more ground in percentage terms just to restore the original value of your capital.
To demonstrate, on 19 March 2020, its lowest point in the year-to-date, the JSE All Share Index (ALSI) had shed 33%. So, if you had invested R100 in the stock market at the beginning of the year, your investment’s value would have dropped to R67 at the market bottom.
The market then rallied again, climbing some 33.8% between 19 March and the end of April. But because this rebound was calculated off a lower base or starting point, the market was still down a total of 10.4% year-to-date on 30 April 2020, as shown in the graph below. So, despite the April bounce back, your investment would still have been worth only R93.
This is not to say that you should not invest in equities. Nor is it to say that you should allow panic to drive you to sell out of equity and convert your portfolio into cash assets, thereby locking in your losses. Panic and fear-based decisions are just as damaging to investment outcomes as decisions made from greed.
Instead, by limiting your losses through betting on more than one horse, or through diversifying and investing across a range of different asset classes, your portfolio will not have to claw back as much lost ground when market downturns do happen.
THE BENEFITS OF TRUE DIVERSIFICATION
True diversification simply means holding different elements in your portfolio which will behave differently given the same event. Some may think that this is a “spray and pray approach,” but only housing your hard-won wealth in a single asset class means you are backing a single outcome. “The future will surprise” is core to Citadel’s investment approach – and it invariably does.
Importantly, asset allocation is also not a static process. One can and should turn risk taps on and off from time to time. This means weighting up your more defensive asset classes and alternatives at the appropriate time, and gradually re-adjusting this ratio as the environment changes. The goal is to reap the rewards of steady compounding through stability of returns. Critically, asset allocation is not about trying to time the market either.
However, despite the importance of risk management as a first principle in investing, recent events have again demonstrated the weakness or lack of protection in many investors’ portfolios. This is especially true of those who allowed the 10-year bull market to lull them into complacency, allowing greed to override the need to diversify, as equity markets kept climbing higher. The most common rationale for not reducing risk after a strong run of performance is the taxable accumulated capital gain. But, as we have seen, markets can take this gain away at any time. A good investment decision should consequently always trump what seems to be a good tax decision.
That said, the unanticipated “black swan” event of the COVID-19 crisis sparked a sell-off across the board, generating losses in equity, bonds and property, and challenging many investors’ ideas of diversification. Effectively managing investment risk for a range of market conditions, therefore, requires thinking beyond simple diversification, to potentially introducing alternative asset classes into portfolios such as hedge funds and protected equity, which perform completely differently when markets come under pressure.
To demonstrate the point, consider the below example comparing the performance of the JSE ALSI and Citadel’s Combination Portfolio over the five years to the end of April 2020. As a diversified portfolio, the Combination Portfolio blends nine local and global asset classes, including equities, bonds, property, hedge funds and protected equity.
While past performance is not a guarantee of future returns, this example shows how a diversified portfolio may underperform when equity markets are running, but offers valuable protection and resilience when equity markets nosedive – which has meant that it has outperformed the market over time. This outperformance has been consistent over one, three and five years. In fact, the difference is particularly evident over five years, again emphasizing the power of compounding in a portfolio.
In the three months to 30 April 2020, where the JSE ALSI shed 8.8% as a result of the March sell-off, the Combination Portfolio was essentially flat. This means that in the 12 months to the end of April, where the market was down 10.8%, the Combination Portfolio was in fact up by 2%. Over five years, where the market gained 1.6% annually, by limiting investment losses and utilising effective diversification for investor protection, the Combination Portfolio instead delivered 6.5% per annum.
A FORWARD-LOOKING APPROACH
This said, now is not the time to simply crowd into assets that performed relatively well during the crisis and subsequently bounced back. Notably, the recent equity rally is unlikely to be sustainable. Many global shares are looking expensive, and investors who climb in now without looking at the fundamentals may be in for a rude awakening should another market correction take place, or may find that the upside is simply muted and disappointing as shrinking earnings take their toll.
Equally, investors should be cautious of buying shares simply because they are cheap – the pandemic has completely changed the local and global economic environment, and many companies may never recover.
In other words, it is crucial to take a forward-looking approach, and if you are at all in doubt or would like to discuss your investment strategy further, consult a professional financial adviser for expert advice. Remember that, ultimately, your investment decisions are only as good as tomorrow’s returns – not yesterday’s.
For more information, listen to Nic Horn on Classic Business with Michal Avery, click below.