When taking a look at 2006, the typical investor could be forgiven for thinking that the ‘good times’ that we experienced over the last three years have continued unabated.
The JSE has enjoyed nearly 120% growth since the beginning of 2003, and almost all investors who have had local equity exposure have benefited from this extraordinary performance. This performance has, however, had another effect – it has made many investors overconfident. This in turn has created unrealistic expectations in investors’ minds, and has also resulted in investors investing in various instruments without being fully cognisant of the risks involved.
2006 has seen the re-emergence of bi-directional volatility as a factor in the investment environment. After nearly three years of mono-directional upward market movement, May and June 2006 gave many investors a, perhaps overdue, reality check, with markets losing nearly 20% in two weeks. The concept that risk and return are related and that there actually is a downside to risk was reinforced in no uncertain terms.
But what does this mean for the average investor? 2006 has reinforced that investors should properly assess their investment strategy, by first realigning their expectations.
Greater Expectations
The past three years have made some investors believe that 40% per annum performance can be taken for granted – that it is the rule as opposed to the exception. But it isn’t! The last 3 years have been an anomaly in terms of performance – something that is unlikely to be repeated for many years.
So what is realistic? A good starting point is to look at historical returns over an extended period of time. Over the past 30 years, the JSE has achieved approximately 18% per annum. But this is the new South Africa – how can our past performance be an indication of our future prospects?
While many fundamentals have remained the same, there have been significant changes to the structure of the SA economy. Changes in fiscal and monetary policy have resulted in a significantly lower inflationary environment, and the change in the political dispensation has resulted in significant opportunities for economic growth and development. So, to use a historic figure as the basis for our future estimates may not be reasonable.
To get back to our question about realistic expectations, let’s look at it from a different angle. What are the basic components of a realistic return? Firstly, investors must be compensated for inflation, secondly for economic growth [GDP], and finally for the risk associated with investing – interpreted in figures as follows:
- The reserve bank has an inflation target range of 3-6%
- GDP growth is around 4%
- A fair equity risk premium for SA is approximately 5%
Thus, a simplistic estimate for an expected return in equity investments is in the region of 12-15%. While this method is by no means an exact science, it gives us a useful benchmark to assess our long-term performance.
The implication
How does having a realistic benchmark help us? The first outcome is that with lower expected returns, time horizons are going to have to change. The 40% returns of the last 3 years have meant that many investors have achieved their financial goals in record time. This situation is not going to be repeated in the near future and thus investors are going to have to shift from a short-term mindset to a long-term outlook. In practical terms this means that investors who have had great success with strategies that can be loosely defined as speculative will have to pay far more attention to their long term strategy, and to do this they will have to focus on asset allocation.
The implementation
Now that realistic expectations have been re-established, it is important that investors revisit their investment strategy. To do this, the following framework can be used:
- Set your financial goals.
- Calculate the required rate of return to achieve these goals.
- Examine the asset allocation required.
- Assess risk attached to this asset allocation.
- Adopt the investment strategy or adjust your financial goals if the risk attached to the asset allocation is not commensurate with your personal risk profile.
Conclusion
There are a myriad of products and funds available in the market that need to be thoroughly assessed and blended to give you the perfect mix required to achieve your financial goals. This can be a daunting task. We recommend consulting a qualified financial advisor who can give you the independent, broad-spectrum advice that will assist you in making an informed decision. The perfect reaction to this opinion is not to rush out and cancel all your investments and start again, but rather to carefully assess – preferably with an advisor who you feel comfortable with – your product, cash flow, portfolio and life policies. Quite often, institutions can and will accommodate simple changes to the product or portfolio and these can make an incredibly positive change to your investment outcome.
