Risk and return

RISK AND RETURN

We often hear the words risk and return mentioned in the same breath.  Whilst in an ideal world we would want the highest possible return for the lowest possible risk but when investing we often find that risk and return are highly correlated, the higher the return, the higher risk taken to achieve that return.  In this month’s financial view, we unpack the risk and return profiles of a number of different asset classes and how that impacts portfolio construction.

The obvious starting point would be to look at why one needs to take some risk to generate a return.  Risk is generally viewed as the degree of uncertainty and/or potential financial loss inherent in an investment decision.  Simply put, what are the chances of ending up with less money than you invested.  The most certain retainer of value would come at no risk which one can view as cash.  A R10 bank note will still be a R10 bank note in 5 years’ time although the spending power of that R10 may well have diminished through inflation.  Due to the effect of inflation on your purchasing power, one cannot simply sit on the side-lines with your money under your mattress as you are losing value in real terms.  We probably all have memories of spending loose change on sweets when we were young, but now many of those small denomination coins aren’t even in circulation anymore.  That is the stinging power of inflation.

So, one of the main objectives of investing must be to get a return that outperforms inflation (a real return), this is the only way to really increase your wealth.  There are 4 asset classes that we want to explore in this financial view, listed from lowest risk to highest risk:

• Banking Products “Cash and near cash investments,”
• Bonds and corporate debt,
• Property,
• Equities.

Banking products

The business model of a bank is relatively simple.  They borrow funds from those that have excess and lend out to those that are short of funds.  The interest rate that the bank pays to its depositors is far less than the interest rate that they charge to their book.  The differential in the interest rates is profit for the bank and is used to cover various costs and hopefully result in a net surplus.  In South Africa that interest rate differential is general around 4%.

An example of this is that the Repo Rate of South Africa is currently 3.5%.  This is the rate that the banks can borrow money from the South African Reserve Bank.  The bank will typically pay a lower rate to depositors than that.  The prime overdraft rate which tends to float in line with the Repo Rate is currently 7%.

Time is a factor with banking products.  The longer that you are prepared to deposit your money with the bank, the higher the rate of interest they will pay you (the bank needs long term deposits to provide certainty of capital against their home loan book for example).  Investments into fixed deposits and notice accounts will earn higher interest.

Risk related to banking products is low as you just need comfort that the bank itself will still be around when you need access to your funds.  This however isn’t always a guarantee as depositors in VBS can currently attest to. Usually if the rate offered by the institution is much higher than the general market – be careful.  As the saying goes, if it seems too good to be true, it usually is too good to be true.

Returns in banking products are not great at the moment with the very low interest rate environment.  It is expected that inflation will continue to tick up with a higher oil price feeding through so your bank deposits/products will probably not deliver a real return over the next few years.

Bonds and corporate debt

A bond is a fixed income instrument that works like banking products in that you will lend money to generate interest income.  Where the bond differs is that they are normally issued for a far longer term and there is no requirement for the borrower to repay the loan before the agreed/maturity date. The Government (and some large companies like Transnet, Telkom, ESKOM and SASOL) are regular borrowers of money.  They issue bonds that invite investors to lend money to them.  The bond will set out the interest rate the borrower will pay, and the date on which the loan will be repaid.

Because of the long-term nature of the product the return often needs to be higher than the short-term rate.  You are providing funds for a longer period and thus there is a lot more time for something to go wrong.  Investors refer to a yield curve and typically the shorter the duration, the lower the yield.  The current yield on the South Africa R186 bond (maturing in 2026) is 7.235% while the yield on the R2030 bond (maturing in 2030) is 9.135%.

As mentioned above, the longer-term nature of the product means that there is more time for an unexpected event to cause loss of capital.  The main risks for bonds are interest rate risk and credit default risk.  The market value of a bond at any point in time depends on the issue rate and the current interest rates.  Any movement in the current rates will affect the capital value of the bond, where that price of the bond can increase or decrease.  By way of example, let’s say you own a bond that is worth R1 million, which is currently earning 8%. If interest rates now increase to 10%, the market value of the bond will fall because no investor will be prepared to pay R1 million to earn an 8% return when they now can earn 10% elsewhere!

Bonds trade on the Bond Exchange so one can always exit out of a position by selling to another investor, even if the borrower has fixed commitments to only settle at maturity.  They’ll settle the amount at maturity to whoever happens to own the bond at the maturity date.  Bonds will give you a higher return than cash, but they do come with the introduction of interest rate risk.

Property

Many South Africans love property as an asset class as it is drummed into you from a young age that it is always better to buy than rent.  With property, your money is tied up for a long time, you usually have to make a substantial deposit and you can have problems with tenants, so it is an asset class that you either love or hate.  Even in our own office we have so many contrasting views on property.  Is it similar to a bond, is it like equity or is it a combination of the two?  Once again, the concept is pretty simple.  One owns the investment property to earn a rental income stream.

The return (monthly rental income) earned is typically in the high single digits as many investment property owners still have a loan to settle on that property, the rental needs to at least exceed this hurdle rate.  The property can also appreciate in value which will enhance the return when the property is eventually disposed of.

On the flipside you have the risks of interest rate risk (your loan repayments increase quicker than the rental income), you have credit risk (the risk that your tenant defaults on payment) and you have vacancy risk (the chance that your property is unoccupied and thus not earning any income, besides capital growth).

Property thus can be said to offer the potential for a higher return than the existing interest-rate based assets (Banking products and Bonds) but does come with a substantially higher level of risk.

“Equities should deliver the best returns over the long term…”

Equities

Equities should deliver the best returns over the long term but over the short term are more volatile than any of the other asset class.  When you invest in the stock market you are taking ownership of the innovation and product suite of that company.  You invest in a company because you believe that the company will have an ability to grow its earnings into the future.  The return that you get from the ownership of the shares you own are dividends that are paid to you whilst you own the share, and any amount that you realise when you decide to dispose of your holding as a result in the growth of the share price (and vice versa if the company under performs).

Equities do deliver good returns in the long term because well run businesses can adapt their product mix to take advantage of market opportunities.  Unfortunately, companies have different moving parts and unforeseen negative events can impact their fortunes.

Over the long-term equities normally average a return of around 15% but you can have many poor years (as we saw from April 2015 to March 2020) and you can have a bumper year such as the 36% earned in the last 12 months.

Conclusion

Ultimately return is determined by what you pay for the asset upfront.  If you buy at a good price when there is value, you should always earn a decent inflation beating return.  If you buy when the market is expensive and pay over the top you will struggle to recover your initial investment.

We at Magwitch are big equity bulls and we believe that this asset class needs to form the foundation of any portfolio and you need to stick with the asset class for the long term.  We also know that the stock market doesn’t move up in a straight line so for the best results one needs to have a diversified portfolio that considers all asset classes to protect against negative events.  The ideal mix between the two differs from investor to investor and thus when putting a portfolio together it is always best to consult an expert who can match the asset classes against your objective, risk profile and time frame horizon.