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Finding Balance in a World of Extremes

Francis Marais, 2 October 2018

We as South Africans sometimes tend to be overly pessimistic or anxious. In fact, according to the latest 2017 perception index as compiled by Ipsos, South Africans ranked highest in terms of misperceptions.

Misperception can go both ways of course, however, South Africans' misperceptions tend to be more negative, and according to Consultancy.co.za "demonstrate a rather pessimistic national outlook." Considering where we came from and the difficult period over the previous nine years, who can blame us?

Experiences influence other spheres of our lives

It is, however, interesting to observe how these experiences permeate to other spheres of our lives. A case in point was a client who recently requested us to build a portfolio for him with the following two assumptions (1) the rand depreciates to R20 versus the USD AND the JSE loses 31% of its value to end at an index level of 40 000. Either of these could be seen as extreme, tail events, however, both are entirely possible.

While most clients might not articulate their anxieties as succinctly, it is clear many investors are concerned about the current global and local investment environment. So how do we go about building a solution that is essentially future proof?

Completely avoiding risk and sitting in cash is a bad idea

At Glacier we have released quite a number of presentations and articles over the last three years arguing why disinvesting or completely avoiding risk and sitting in cash is a bad idea. It is a bad idea mainly because we haven't yet been able to identify anyone who is consistently good at timing the market. You might be lucky to get the original decision right and miss the crash, but you also need to get the decision right to move back to growth assets and for this strategy to be successful you need to get both right. That is far more unlikely. You are far more likely to be successful in your investment strategy if you stay invested, by sticking to your investment plan and not making short-term tactical decisions.

The graph below shows a previous extreme, systemic event, the Global Financial Crisis or more colloquially - simply referred to as the GFC. When would you have switched out of equities and into cash? When would you have switched back to equities? The problem with a crash is that it very rarely happens all at once; it's a process and there are a series of decisions to get 100% right. The recovery, however, is unannounced and missing those initial upswings will have a major impact on your future wealth.

Getting decisions 100% right consistently, is almost impossible. If it does occur, such as getting the correct sequence of numbers on your lottery ticket correct, it's mostly luck, or extreme skill which is very rare and seldom consistent - or it's Bernie Madoff Markus Jooste.

Behavioural biases affect decision-making

By now most of us who invest must be aware that we suffer from certain behavioural biases. These biases are very powerful and have a strong influence on how we invest and make decisions. Indeed experimental psychologists have found that human beings very rarely make decisions as forecasted by classical economic theories.

I like using the following framework when looking at my own investments, especially my retirement savings, as it challenges me to determine how certain I really am of anything.

For instance if I'm 100% certain of my negative hypothesis, then I should have 0% exposure to risk, or growth assets. On the other hand, if I'm 100% certain of my positive hypothesis then I should have 100% exposure to risk. In between these certainty levels lies a continuum of infinite possibilities and therefore an infinite amount of combinations of exposure to risk vs no risk.

The crucial part of this exercise is that you need to be very honest (and humble!) with yourself and ask yourself how certain you really are. I doubt many of us will ever be 100% certain of anything, i.e. 100% certain of your bad prognosis or 100% certain of your positive expectation. This therefore means that I need to always have some exposure to risk, i.e. a diversified portfolio.

Questions to ask yourself when deciding to make short-term tactical changes

"The little incidents and accidents of every day fill us with emotion, anxiety, annoyance, passion, as long as they are close to us... They were big only because they were near." The quote is by Arthur Schopenhauer from his Studies in Pessimism. What he is trying to point out is our inability to take a step back to gain perspective, and that short-term experiences are challenging, because we experience them intimately. However, when we do take that step back, and gain perspective we might look at risk differently. We might see that things move in cycles, the rand depreciates but also appreciates, shares become expensive, but also become cheap, and bond yields blow out and then come back down again. We might even see opportunity. A wise man might lead a powerful nation, followed by a clown (and then vice versa).

So, ask yourself whether you are 100% sure of your convictions. Are you 100% sure that South Africa is going to become a failed state? Are you 100% sure about when the next market correction might happen? Are you 100% sure that cash is your best alternative? If you are honest with yourself and you are not sure, then you should be careful of short-term tactical decisions.

To build portfolios that are future-proof, investors need to have a long-term investment plan, with a well-diversified investment portfolio and stick to this plan. Enlisting the help of a qualified financial adviser provides an objective voice of reason and can provide invaluable guidance during times of increased market volatility.

What about new investments?

What about new investments, especially for those investors who are transitioning from pre-retirement to post-retirement? This is a particularly vulnerable period, where the sequence-of-returns can have a meaningful impact on the sustainability of their retirement savings pot.

Here a variety of strategies may be used, such as:

  1. Utilising the Sanlam Monthly Bonus Fund as part of their investment strategy
  2. Phasing-in – yes I know about all the literature out there that points to the negative aspects of this strategy, but this research very rarely specifically address sequence-of-return risk and the accompanying behavioural benefits. It's much better assisting a client to get their strategic asset allocation right, than a client who avoids risk by staying invested in cash.
  3. Multi-Asset Income funds also provide a good alternative to pure cash, especially in terms of more diversified risk exposures, while offering good yields. Should the client be totally unwilling to take on equity risk, these funds can be utilized, and risk can be slowly introduced as the client becomes more comfortable with additional risk exposure in future.

Conclusion

From a balance of probabilities perspective, considering the long, extended bull market we have experienced it makes sense to be cognisant of risk inherent in the markets. The difficult part, though, is getting the exact time of both the drawdown and recovery correct. The focus should therefore be on the long term, together with a well-diversified portfolio and prudent financial advice from a qualified financial adviser, which would go a long way in mitigating these risks. If the investor is, however, transitioning into the post-retirement phase of their life, a long-term investment plan together with some smart risk management techniques and uniquely positioned products might be the best way to go.


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