Investing in turbulent times

Pierre Muller, advisory partner at Citadel.

These are turbulent times. If we were on an aeroplane we would have our seat belts firmly fastened, our jaws clenched and our fingers firmly clasped around our arms rests. And we should probably just get used to it.

The economic forecast for 2016 is bleak. The JSE FTSE All Share Index is down 5% over the last 12 month period. The slowdown in China and start of US interest rates hikes are throwing global markets into a tailspin. On the domestic front, South Africa’s worst drought in decades is compounding existing economic, political and social challenges.

For a long-term investor who wants to take calculated risks in the market to realise real returns, this kind of economic environment offers many opportunities. In Warren Buffet’s words, “be fearful when others are greedy and… greedy only when others are fearful.”

The problem comes in overcoming the emotional hurdles that stand in the way of investing and remaining invested in an environment like this. We are emotional beings. We don’t like to see our portfolio decline 15%. And when it’s up 15%, we expect more of the same. We are naturally wired to make decisions based on the fear of losing and greed for more.

We all know the basic principles of sage investing:

• Don’t sell when the markets are in decline, buy at a discounted price instead.
• Be cautious when the markets are at all-time highs, you might be paying too much.
• Don’t try to time the market, rather spend sufficient time in the market to achieve the necessary returns.

These basic principles have served investors well over decades. However, trouble creeps in when we start to think “This time it’s different”. How do you avoid the trap of being swayed by your emotions?

1) Sound, long-term financial planning

Your financial advisor should spend time getting to know you and your family so as to get a firm understanding of your goals, your concerns and your risk appetite. Thereafter they should construct a holistic financial plan which takes into consideration your current financial position; your investment goals and the time horizons associated with these goals (such as tuition fees, wedding costs, overseas holidays, etc.); retirement planning; estate and fiduciary planning; tax planning and risk management.

A sound financial plan doesn’t focus on products. It offers a roadmap to attaining your goals. And it should be robust enough to withstand short-term trends. A plan shouldn’t change in response to market movements, but rather if the fundamental factors upon which it’s built change.

Markets will continue to rise and fall as they have done over the past 100 years. Each time you listen to the media and start to think “this time is different”, you need an advisor you trust that can encourage you to stick with your plan and keep your emotions in check.

2) Understand your investment plan

If you understand how your capital has been invested and why it was structured in a particular way, you are more likely to trust the fundamental principles of your plan when markets fall.

According to Brinson Hood Beebower (1986/1990), 94% of investment return is based on the asset allocation decision (the optimal combination of equities, bonds, cash, property, hedge funds, local vs offshore) rather than market timing or investment performance. Asset allocation also offers the opportunity for investing offshore and rand hedging in order to further diversify your risk.

Risk-return and asset classes

Each asset class has its own risk-return characteristics (see Chart 1 below). Equities provide the highest real return over the long term but are volatile in the short term. Cash, on the other hand, has far less volatility but seldom offers returns above inflation with sufficient real return in the long term. Consequently, each asset class has a role to play in a diversified portfolio if one is to manage risk and enjoy real returns above inflation.

The chart below illustrates Citadel’s assessment, over the next three years, of the potential risk-return characteristics of the asset classes that we monitor. Apart from global equities, the chart clearly demonstrates that the asset class return differentiation is muted and risk optimisation will be crucial in portfolio construction to ensure real returns are achieved over the next few years. Asset allocation in a low returns environment will be key to ensuring optimal portfolio returns.

Chart 1 – Risk-return spectrum of asset classes

Source: Citadel Asset Management

Your portfolio should be structured in such a way that the right asset classes fund the goals with an appropriately suited time horizon. For example, the equity component of your portfolio should fund long-term goals. If you have an eight- to 10-year time horizon, equities provide the best real return and in terms of risk the standard deviation is only marginally higher than bonds.

At Citadel, our asset and liability matching philosophy ensures that your asset allocation is in line with the risk return characteristics of the underlying assets over time. What does that mean for you? It means that we anticipate the equity component of your portfolio to be volatile and to go through periods of negative return. We factor this into our financial plans so that our clients can sleep well during times of market turmoil.

Benjamin Graham said: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

At Citadel we provide that for our clients. We build a thorough long-term road map using a sound intellectual framework and then as a partner we walk the road with you, to help you reach your goals when emotions tempt you to deviate from your plan.