Is the current market volatility the new norm?

The sub-prime crisis forced individuals, retail investors and regulators to rethink their respective roles. One of the concepts they had to get to grips with was that no bank was "too big to fail”. Commercial banks and savings institutions fell like dominoes as liquidity in the global financial system dried up.

Of the 454 US financial institutions that have failed since the beginning of 2000 a staggering 427 occurred as a result of the global financial crisis that started in 2008!

Against the backdrop of high volatility and dire global growth forecasts investors have understandably shied away from investing in growth assets like equities and listed property. A diagram of key variables pre and post-recession outlines just how much the US and South Africa economies have suffered over the period.

Four years down the line there is a perception that global markets are still very volatile. In reality, market volatility peaked at the end of 2009 and has since subsided to pre-recession levels (see diagram). It seems that there is finally some light at the end of the tunnel.

Although volatility is subsiding we could still suffer "aftershocks” as a direct consequence of the global financial crisis. The ongoing sovereign debt concerns playing out in Europe is one example. As time passes the post-crisis shocks will reduce in frequency and magnitude, thus allowing market volatility to dissipate further.

What is currently the greatest risk to investors? Individuals are not at risk from volatility but rather their decisions to reduce exposure to riskier asset classes such as equities, both during and after the global financial crisis. Their appetites for investment opportunities at higher levels on the risk spectrum have undoubtedly been quelled!

The risk is that investors are too conservatively positioned compared to their risk profiles. In the current low-yield environment the danger is that investors will not generate the growth needed to retire comfortably. This risk is compounded by advances in medicine and living standards that will see developed-world life expectancies increase from one generation to the next.

Investors must ensure that they plan for a long life and invest a portion of their money into growth assets in order to beat the erosive effects of inflation. Their best option is to stick with growth assets such as equities, which generally outperform other asset classes over the long term. Another trick to ensure enough capital at retirement is to side-step the dangerous "timing the market” game.

First, you must determine whether your client’s portfolio has adequate exposure to growth assets. This is especially relevant to investors that are drawing an income from their investments.

If your client’s portfolio is not generating a decent growth rate over time, they will be forced to draw down their capital. Being invested in a money market fund over the last ten years would have generated an average return of only 8% per annum.

Assuming a tax rate of 30% your net annual return would have been approximately 6%. And assuming an income drawdown of 7% per annum (1% more than the average annual net return) your client would have drawn down 11% of his or her invested capital. The initial capital investment would have shrunk by 11% over 10 years.

Had you opted to invest your client’s capital in a balanced fund instead, your portfolio would have generated an average return in the region of 14% per annum. If we assume the same tax rate (30%) and income drawdown (7%) the capital invested in the balanced fund would have grow by 30% over the period.

The second consideration is whether the client’s portfolio is diversified globally. Herman van Velze, portfolio manager of the STANLIB Balanced Fund, highlights that an important part of building a diversified portfolio is the inclusion of global investments.

The group’s research shows that spreading investments across different countries (asset classes, industries and currencies) is an effective way to produce better risk-adjusted returns compared to investing only in South Africa.

And research conducted over a period of 40 years shows that your client’s risk/return ratio improves by 15% if you invest 30% of your assets offshore. This means that your client has a lower risk exposure for a similar return.

Now is as good a time as ever to diversify offshore, because global equities offer relatively better value compared to South African companies. Some of the biggest global companies’ price-to-earnings (PE) ratios are lower today than 12 years ago.

If you buy these shares today then you are paying relatively less for every dollar of earnings compared to 12 years ago. This is a fantastic argument for including offshore equities in your client’s diversification strategy. Investing in a balanced fund is an easy way to ensure that your clients are well diversified as the fund manager actively manages asset allocations between local and global asset classes.