Why capital preservation is your best bet in uncertain economies

Gavin Smith, Head of Africa at the financial services firm deVere Acuma.

It’s been a torrid year for the South African economy. Political instability, coupled with credit downgrades and rising levels of unemployment have paved the way for increased uncertainty. In uncertain times the typical inclination of most investors is to sell shares and move into cash, thereby minimising any further risk to their investment portfolios.

However, a better strategy is that of capital preservation, advises Gavin Smith, Head of Africa at the financial services firm deVere Acuma.

Liquidating a portfolio, he says, is often a knee-jerk reaction. It’s also an action that comes with its own risks. This includes the monetary loss associated with liquidating a portfolio, and the opportunity cost of placing money in low yielding bank accounts and money market funds. Despite the market’s lacklustre performance in the first half of 2017, it recovered in the second half of the year with the JSW All Share Index looking to have a positive return for the year. Had investors liquidated their stock portfolios mid-year, they would have missed out on the market’s growth in the past few months.

Smith says that pulling out of the markets entirely is betting against financial history, as markets do recover. “Rather than liquidating portfolios in uncertain or volatile times, capital preservation is a better strategy. The goal of capital preservation is to preserve capital and prevent loss in the portfolio by investing in a fully diversified portfolio, which protects against market volatility.”

Sitting tight and riding out short-term market shocks – and leaving the portfolio as is – is not as risky as it sounds, assures Smith, so long as the portfolio is correctly constructed and sufficiently diversified in the first place, and regular rebalancing is done to ensure the intended balance of assets remains in place. “With the right mix of assets, and taking into consideration the overall long-term rising market trend, it’s often the best way to ensure capital preservation. Being able to sit still, and ride out a period of volatility without feeling the necessity to sell while re-investing dividends back into the market, is a key element of long-term wealth creation.”

Volatility targeting, which prioritises the estimated risk an investor assumes, rather than an estimated return, is a relatively new financial innovation that helps to reduce risk by matching a client’s risk tolerance with a particular mix of equities and bonds. Volatility target strategies outperform equity on a risk-adjusted basis according to a recent study on the subject by Stanlib investment manager, Bhekinosi Khuzwayo and Eben Maré of the Department of Maths and Applied Maths at the University of Pretoria. Amongst deVere’s product offerings is a volatility-targeted portfolio designed by Pacific Asset Management, a London-based multi-asset fund manager.

Despite some positive economic indicators including a recovery from the second quarter’s technical recession, a recovery in agricultural output and expanded manufacturing outputs, Standard & Poor’s announcement last week that it has reduced South Africa’s local currency debt to one notch below investment grade caused the rand to lose further value. Ratings agency Moody’s has threatened a further downgrade in the new year indicating that South Africa’s economy remains in a precarious position with further market volatility a given.

“Caution is still the word of the day,” warns Smith. “Political instability is the biggest driver of low business confidence, slow GDP growth and dwindling future investment should the country be further downgraded.”

Extreme knee-jerk reactions to market conditions can, and should, be avoided, he advises. “It’s a good idea to consult with a financial advisor for personalised financial advice that is tailored to your specific needs and then to configure your investments in the best way possible to maximise wealth,” he concludes.