When we consider the last three years’ market-related data, I think it’s relatively safe to say that most investors feel like an extremely tired boxer in the middle of a very long boxing match. Graph 1 below clearly shows us that between local shares, offshore shares (in ZAR) and local bonds, local bonds was the only asset class that (before taxes) managed to outperform inflation over this period. This means that at the maximum tax rate of 45%, no asset class really managed to outperform inflation after taxes over the last three years.
While no one can predict what will happen in the next three years, I still get the feeling that following the market rally between 2012 and 2015, too many investors have become a little sloppy with their personal risk tolerances.
Three years may feel like a lifetime for some, but in the investment world, it’s still a relatively short period. When we consider current market conditions then, how do we rise above this when good returns are usually the main focus of any investment company’s sales pitch?
Considering risk adjusted returns (RARs) is definitely one of the best options available out there to protect investors. It is generally accepted that as the expected returns on investments grow, the risks taken to achieve that growth also increase. The RAR shows the returns on an investment for every unit of risk taken.
This ratio is especially effective when comparing different investments to one another, and when trying to determine if the returns of a particular fund can be attributed to good investment decisions or additional risk taken. This tool, unlike many investment experts, doesn’t only look at a specific investment’s or asset class’s historical returns.
The RAR is also known as the Sharpe ratio and it is determined by deducting the risk-free rates from a fund’s rates and then dividing it by its volatility (standard deviation).
It is a good relative ratio and all investors have to do is look for the investment with the highest ratio (highest returns relative to the least amount of risk or volatility).
A good example of this can be seen when we compare the South African General Equity sector to the South African Multi Asset High Equity sector (which is limited to 75% exposure to shares). For the more conservative investor, the volatility of shares may carry significant weight in the decision to seek potentially higher returns. Over the long term, shares may outperform other asset classes such as fixed interest investments, but it doesn’t happen in one straight upward movement. There will always be a few glitches and like any boxer, the market also takes quite a few hits.
If we consider the last 10 years’ data (May 2008 to May 2018), for example, we started this period off with one of the greatest corrections of all time, followed by a recession until 2012, a solid rally until 2015 and basically no growth since then. This is definitely one of the first decades where returns on local asset classes didn’t really differ from each other, with an ending that seems very similar to that of the children’s tale about the tortoise and the hare.
The General Equity Unit Trust sector and the Local Multi-asset High Equity Unit Trust sector delivered nearly matching returns over the same period (7.8% per year), but it’s the Sharpe ratio that paints a clearer picture: although the returns in these two sectors were nearly identical over this 10-year period, the Local General Equity Unit Trust sector experienced nearly 70% more volatility.
Don’t get me wrong -I’m definitely not saying that shares are a poor investment. But I would like to firstly point out the importance of a well-diversified investment portfolio. Secondly, it is extremely important that you don’t only look at historical returns when you consider making a new investment, but also at the risk-adjusted returns. Like Warren Buffett said: “Only when the tide goes out do you discover who’s been swimming naked.”
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 herein. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.