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Leopards don't change their spots

02 March 2007 Ryan Jamieson Momentum Wealth Investment Marketin

Introduction

Equity markets around the world have once again displayed their proneness to short-term volatility and fluctuations in price and have reminded investors of the risks associated with holding too much exposure to equities in a portfolio. This is not to say that investing in equities is a bad thing. It is merely to suggest that exposure to shares (equity markets) within a portfolio should be appropriately aligned with the term of the investment, the strategic aim or purpose of the investment and an acceptable level of risk, in pursuit of these objectives.

Markets, both locally and globally, have produced sound real returns i.e. returns ahead of inflation, over the medium to long term, but have often done so at levels of risk that are higher than say, bonds or cash. For this above average risk, investors have been handsomely rewarded with stellar returns from equity markets in recent years. But returns have not always been a one-way bet. Bull markets are generally interrupted by a few corrections along the way. Apart from the 1987 crash, the great bull market of 1982 to 2000 experienced setbacks in 1990, 1994 and 1998. Remember the equity market sell-off in May/June last year?

Investors have been handsomely rewarded

Investors exposed to the local equity market, for example, would have noted with absolute elation that despite a few short-term glitches, the JSE All Share Index had gained roughly 300% since late April 2003, and that annualised returns in the region of 40% were translating into handsome gains in their respective portfolios.

Global equity markets had also delivered the goods since late March 2003 (following a few years of declines), and rewarded investors with returns of 100% and more from certain markets. Annualised returns from global equity markets have been lower than those posted locally (moderate double digit returns to roughly the 30% pa mark).

Investors exposed to these markets, partially or in full, would have seen the benefit of this strategy (being exposed to equities) in terms of profound increases in fund values on an ongoing basis. But as conventional wisdom reminds us, nothing can increase at an above average rate on a sustained basis infinitely and that what goes up, also comes down.

The calm before the storm

The 'Buttonwood' column that appears in The Economist, carried an article entitled "Before The Fall" on 15 February 2007. The article claimed that an uneasy calm had settled over financial markets around the world and that a move to a state of nervous anticipation was under way. Things had simply been going too well and a market correction seemed overdue.

A correction materialized within a fortnight of the article.

A correction resides somewhere between a market crash (like "Black Monday" that occurred in October 1987, when the Dow Jones Industrial Average fell 22.6% in one day) and a bear market (when markets enter prolonged periods of falling share prices, as was the case when UK shares fell by half from March 2000 to March 2003). A correction is, in essence, not as violent as a crash nor as prolonged as a bear market.

China crises

China's stockmarket suffered its biggest one-day drop in a decade on Tuesday, 27 February 2007. Asian and European equity markets followed suit, with many European markets ending 3% lower on the day. US equity markets fell by their biggest margins (in excess of 3%) since the markets reopened after the terrorist attacks of 11 September 2001.

The reason behind the almost 9% drop in the Chinese stockmarket came about as investors became spooked that the authorities would clamp down on irrational exuberance that had taken hold of China in recent months. Rumours that the government was looking to impose taxes on capital gains (at a rate of 20%) sparked panic selling. Investors were also unnerved by remarks from Alan Greenspan that the US could possible be sliding toward a recession.

Shares across the Asia-Pacific region closed mostly lower on Wednesday as well, but Shanghai markets rebounded on bargain hunting on the day following the dramatic sell-off, ending almost 4% higher.

The JSE All Share Index fell in excess of 3% on 27 February and just over 1% on 28 February as the rush to sell out of equities gripped investors in the same way as their global counterparts.

Where to from here?

Admittedly, stockmarkets had enjoyed a phenomenal run for more than four years without a correction of 10% or more and while markets are not at excessively expensive levels, they are certainly not considered cheap. Analysts had been anticipating a correction from an overbought market for some time.

The global equity market sell-off may be short lived, it may be a bit of an overreaction and it may also be a temporary set back in an otherwise long-term bull market, but a number of investors, old and new alike, will again learn expensive school fees from these events. Although the months ahead may be choppy as markets find more sustainable trading levels, few analysts expect the Chinese bourses to spin completely out of control.

Exposure to shares or equity markets remains a key component within a well-diversified, holistic investment portfolio. Nothing has changed. Equities provide the opportunity to deliver inflation-beating returns over the medium to long-term, but the exposure to such an asset class should be well explained (and understood) in relation to investment objective, risk and term.

Empirical research has shown that investors experience the pain caused by capital loss four times more acutely than they do the pleasure of a similar-sized gain. It therefore stands to reason that, after a near four-year long bull market, the recent market volatility will have caused considerable discomfort - if not anxiety.

Assuming that the current market volatility is here to stay, what should investors be doing (and/or not doing) to protect and grow their capital? When emotions run high, it becomes difficult to distinguish between objective facts and subjective feelings. Investors should therefore continually remind themselves of the following list of dos and donts:

A short list of dos:

1. Remember your investment objective. If your investment objective/risk profile implies a particular strategic asset allocation (e.g. a young investor should have significant equity exposure), short-term jitters should not affect the long-term strategy.

2. Maintain your strategic asset allocation. If the chosen strategic asset allocation is appropriate, then it should be maintained. If, for example, an equity market correction causes the equity component of one's portfolio to drop below the original level capital should be switched out of other asset classes to top up the equity component.

3. Fundamentals matter. Always try to ascertain whether the fundamental outlook for a given market or asset class has changed significantly, and whether the markets perception of change is correct.

4. Have realistic expectations. The phenomenal run-up in South African capital markets over the past four years was a one-off event, caused by a structural shift to a low-inflation, low-interest rate environment. This shift is now over, and investors should accept that returns will be more muted going forward. The long-term return on equity (excluding dividends) is roughly cash plus 6% p.a., and on bonds around half of that. 

5. Get expert help. Retaining the services of a professional financial advisor is beneficial in more than one way: It not only adds knowledge and experience, but also introduces objectivity. As with many other decisions individuals have to make, it always helps to test ones ideas with an informed, objective outsider.

A short list of donts:

1. Do not try and time the market. Experience over many years has shown that market timing is like alchemy - fine in principle, but hard to achieve. It is better to make a sound asset allocation decision (and to stick with it) than to try and second-guess the market - even seasoned investment professionals find this difficult! Research has shown that being out of the market on just a few of its best days can detract hugely from ones long term returns. What ultimately matters is not when one enters the market, but how long one stays in it. This principle obviously only applies to those investors who belong there, and not to vulnerable ones whose risk profiles or time horizons do not allow for equity exposure. 

2. Safety is a relative concept. While it is tempting to seek shelter in cash when other asset classes perform poorly, very few - if any - investors can afford to allow their buying power to be eroded by inflation. Money market funds currently yield rates that are generally negative after inflation, tax on interest earned, administration fees and commissions. 

3. The herd almost invariably get it wrong! History has taught us that public consensus about asset classes and funds tends to be correct, but generally 6-12 months out of date. It takes a while for consensus to emerge, and by the time investors act on it, the easy money has generally been made. Avoid advice based on what has already happened like the plague, and rather heed the advice of informed people who base their views on realistic expectations of the future.

4. Offshore investing is not a zero-sum game. When local markets suffer reverses and the Rand slides, offshore investments invariably come under the spotlight. Investors should remember that it is not a question of local or offshore, but rather local and offshore - the respective weightings might however change over time.

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