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Day traders' success in 2020 belies the value of investment fundamentals

20 January 2021 Old Mutual Wealth

Last year, the Covid-19 pandemic served up a host of outcomes that surprised even seasoned investment professionals. The speed of the global market recovery, for instance, has been outdone by amateur investors who have managed, so far, to beat the returns earned on the S&P 500 Index.

The reason for so many first-time retail investors jumping onto the day-trading bandwagon is blamed on the pandemic curbing sports betting. In response, popular apps like Robinhood have become the go-to destination for people to bet on stocks instead of shots at goal.

"Despite their inexperience and extreme volatility in the markets this year, returns by newbie traders soared 56%, beating the S&P 500 by 45% and nearly doubling the return on hedge-fund favorites,” says Moosa Hassim, Investment Analyst at Old Mutual Wealth Private Client Securities.

“However, despite this short-term success, when it comes to investing, the way we understand and manage risk is what distinguishes an investment from a simple gamble. The ability of a professional asset manager to follow a process based on the outcome of a robust and sound investment philosophy is what separates risk management from mere luck,” he says.

And it is this difference that sets investment professionals apart from amateur traders, no matter how well they may have done in 2020. While many investment managers believe that managing risk through metrics such as beta and volatility is the essence of risk management, Hassim holds a nuanced view.

“It’s equally important to assess the companies’ strengths, weaknesses, competitive advantages and the market environment. Only after taking these factors into account can an investment manager identify their potential for success and continued growth more accurately.”

Hassim says the common belief is that the higher the volatility, the higher the risk, and, over the long term, the higher the return. This is the basis of Modern Portfolio Theory (MPT), which allows for portfolios to be constructed in a way that considers the Risk (viewed as volatility) and the expected return.

“What one needs to understand is that volatility is inevitable. It’s the nature of the market to move up and down over the short-term,” he says. “Risk, as seen by investment managers, is split into systematic, which refers to the risk inherent to the entire market or market segment, and non-systematic risk which is the industry or company-specific risk which is inherent in every investment.

“The former cannot be mitigated through diversification. In contrast, the latter can be countered by investing in stocks across sectors and different asset classes to reduce exposure to non-systematic risk. So, in essence, the first way to consider risk is to ensure you have a sufficiently diversified portfolio.

He adds that it’s equally important that investors are not over-diversified. Research indicates that a concentrated portfolio of around 20 companies offers sufficient diversification while still allowing for the skill of an active manager to outperform the market over the long-term.

“Another tactic increasingly used by investment managers is to give a greater weighting to companies with higher environmental, social and governance (ESG) factors. Research has proven that better-rated ESG companies tend to outperform lower-rated companies, as well as the benchmark, in the long run.

“This is because ESG scores provide insights into the sustainability practices of a company, the quality of its management and its prospects for long-term investment returns,” says Hassim.

“Within our portfolios, all equity holdings are assigned an ESG profile score, which is a quantitative measure that uses both long- and short-term ESG data signals. The score is a blend of long-term MSCI Intangible Value Assessment ratings and shorter-term news flow on potential controversies and accounting risks.

“Combining both provides a more robust approach to assessing the long-term investment risk associated with a company. The blend of the above three metrics takes volatility and performance attributes into account to ensure an optimal weighting,” concludes Hassim.

“Day traders may have won the day due to the coronavirus pandemic, he says, but the only certain way to ensure consistent long-term returns is to adopt an appropriate investment philosophy and robust process with an overarching risk management strategy.”

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