Category Investments

The risks of binary thinking when investing

15 August 2017 Ian Scott, PSG Asset Management
Ian Scott, Head of Fixed Income at PSG Asset Management.

Ian Scott, Head of Fixed Income at PSG Asset Management.

The odds are stacked against accurate market predictions.

Black-and-white thinking is just as prevalent – and as limiting – in investing as it in other areas of life. In investing, black-and-white market views result in binary portfolio positioning, which increases the risk that the outcome you predict will not materialise.

In the fixed income market, it is very easy to become lost in the dominant narrative and end up building a position around that story. It happens all the time. The problem is that reality lies somewhere in-between the black-and-white scenarios.

Constructing non-binary portfolios

Diversification is the departure point for constructing portfolios around non-binary views. There are always opportunities in more than one segment of fixed income markets at any particular point in time. Currently, we believe there is value in cash instruments, government bonds and certain parts of the credit curve.

It’s also important to find assets that are uncorrelated with your highest-conviction positions. Due to legislative constraints, South African portfolios are highly correlated with domestic events and rand volatility. This can be minimised by buying assets that are not affected by South African-specific events, such as offshore cash, hard-currency bonds and real offshore assets (like infrastructure projects).

This allows you to diversify a portion of your portfolio away from the high-probability scenario of markets behaving in the opposite way than expected due to an unforeseen political development, disruption or legislative change.

A binary narrative continues to play out in South Africa

Local fixed income markets continue to build in a binary narrative. There is growing consensus around further sovereign rating downgrades for South Africa – and on what their impact will be.

It’s well known that foreign investors are the largest single group of investors holding South African government debt. Furthermore, since the country’s inclusion in major global bond indices in 2012, the current holding is the largest that foreign investors have ever held.

The black-and-white thinking around this theme is that it is only a matter of time until South Africa’s local currency rating is downgraded to junk status, which will force all these foreign investors to sell their holdings overnight.

The downgrade may or may not happen, and there is no indication of timing. Yet the binary narrative is to be short the rand and South African bonds, as the downgrade will create a massive fallout in local fixed income and currency markets. The reality, however, may end up being different to what is currently being priced into long bond yields.

Firstly, South Africa comprises about 0.5% of the World Government Bond Index – a small overall weight that may not necessarily force a sell-off from all foreign investors. Secondly, if South Africa is downgraded to junk status, funds invested in South African government bonds will not have to rebalance their positions immediately; there will be a transition period. Thirdly, global investors are still in search of yield and buyers of high-yield debt may decide to enter our market due to the attractive opportunity. Finally, being rated as junk status does not mean automatic default; while South African debt metrics are deteriorating, they are still in line with or better than our emerging market peers.

Avoid the risks of inaccurate predictions

Many local investors have taken a negative stance on South Africa, grounded on firm views, forecasts and expectations. This type of thinking should be avoided. Rather buy fixed income assets where you see a sufficient margin of safety, and then determine the weight of your allocations based on the highest-probability outcomes.

Diversify your portfolios away from any single outcome, as this carries too much risk. There is still opportunity in the local government bond market due to factors such as credible inflation targeting by the South African Reserve Bank, bond-positive macro data, and elements of fear and uncertainty that may be distorting valuations. It isn’t prudent to have no exposure to an asset class for which all news is negative and potentially priced in, while the probability of a positive surprise is largely ignored.

Quick Polls


Which aspect do you think is most critical for the future success of financial advisory firms?


Embracing technological advancements
Rethinking fee structures
Focusing on inter-generational wealth transfer
fanews magazine
FAnews June 2024 Get the latest issue of FAnews

This month's headlines

Understanding prescription in claims for professional negligence
Climate change… the single biggest risk facing insurers
Insuring the unpredictable: 2024 global election risks
Financial advice crucial as clients’ Life policy premiums rise sharply
Guiding clients through the Two-Pot Retirement System
There is diversification, and true diversification – choose wisely
Decoding the shift in investment patterns
Subscribe now