The bee has to be one of the most interesting insects around, and seeing one always reminds me of the children’s story of how the bee got his stinger.
The bee got sick and tired of being confused with a fly and having to dodge fly swatters all the time, so he went to Mother Nature and asked her for a weapon as effective as the grasshopper’s hindlegs or the spider’s bite. Mother Nature gave Bee one option that came with a massive risk. She could give him a stinger that he could use to inflict pain on others, but he would only be able to use it once in his lifetime. After using it, he would die.
Because Bee was fed up with being bullied, he agreed to the terms and from that day onwards, he had a stinger. Even though he could inflict pain and even cause death with his stinger, he carried the risk that he too would die if he ever used it.
As investors, we are faced with similar dilemmas on a daily basis. With money market rates currently at around 6.7%, other investment instruments are looking much more attractive. When taking a maximum tax rate of 45% into consideration, investors would have to be satisfied with a mere 3.9% in returns. If all variables were to stay the same, investors wouldn’t even be able to keep up with inflation (currently at 5.1%), so we are literally becoming poorer by the day.
Unfortunately, unlike the bee, we cannot ask for more ammunition. By moving your investment from money market to the slightly riskier bonds, you may (at current interest rates) be able to get a better return of around 9.5% before taxes. But the use of this “stinger” may also bring about some indigestion.
Before we continue, I think it’s only wise to define risk in the investment environment. There is definitely a positive relationship between risk and returns. The standalone risk of an investment is measured by the standard deviation in volatility. It shows the historical volatility limits within which the investment moves (statistical assumption of normal distribution).
When studying the standalone risk of our five leading investment instruments, it quickly becomes clear that the right choice definitely isn’t an easy one, and that the wrong choice can have even more severe side-effects than a bee sting.
As expected, money market definitely carries the lowest risk, but as I mentioned earlier, it also delivers lower returns. Bonds may offer more value on paper, but with a total investment return (meaning interest with the price declines over the last 12 months ending 20 November 2017) of only 4.9% before taxes, the effects of the recent political unrest in South Africa becomes all too clear. Even when we take a look at the annual standard deviation over the last 2 years, 8.2% tends to lean more towards the higher (risk) side.
The weakening of the rand and the strong rally in first world countries’ stocks definitely helped to make offshore investments one of the best-performing investments over the last 12 months. A 50/50% investment in the MSCI All Country World Index and Citigroup World Bond Index would have yielded 11.4% in returns (in rand-terms) over the same 12-month period. But at a standard deviation of 15% over the last two years in rand-terms, it also would have come with the highest volatility.
When we take a look at local shares by only focusing on the FTSE/JSE All Share Index, you would think that it took first place with a whopping 23% returns over the same period. Its standard deviation of 11.2% over the last two years could even be considered as relatively low. But it’s only when we remove Naspers from this equation, that the bee’s stinger becomes visible. Without Naspers, this index would have grown by only 3% over the last 12 months, meaning investors should be very careful not to be swept along by the euphoria surrounding current market conditions.
As an investor, it is important that you don’t focus on only one asset class when you review your total investment portfolio. By properly diversifying your portfolio across different asset classes, you will fight risk in one of the best ways possible, and you won’t end up having to choose between nothing or a stinger that comes with a huge disadvantage.
The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice. This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.