Over the last few years, we have often written articles for this newsletter focusing on why one needs to invest in equities. Over the past five years local equities, and in fact most Emerging Market equities, have produced very little in the way of returns. As a result, many investors flocked into cash, seemingly making investment decisions based on recent past returns and not on valuations and asset class fundamentals. Double digit growth in equities in a single month of November 2020 (more than cash will currently deliver over two years) may make us look clever but we were just sticking to investment principles. In this month’s Financial View, we look at the need for diversification within your portfolio.
As mentioned in the introduction cash has outperformed equities over the past 5 years. This is confirmed in the following graphic which plots the returns of each asset class for the last 20 calendar years. The best performing asset class for each year has been highlighted in green and the worst performing one in that calendar year highlighted in red.
What is important to note in the graphic is that there isn’t one asset class that is the best performer year in and year out. In fact, over the last 20 years the asset class that has been top in the most number of individual years was local listed property. A lot of the outperformance in property during the 2000’s was driven by a reduction in interest rates and then speculation as investors believed that the good times would continue indefinitely. The result has been a spectacular crash as property companies values over the last three years as the companies couldn’t maintain their high levels of debt with a large oversupply of property stock.
The information that we take from the graphic and from investment principles is that the asset classes all react differently to economic events. Currently many investors have followed a risk off approach and are sitting on the side lines in negative yielding assets. A vaccine that will slow down the current Covid pandemic rate of infection will boost emerging markets and one would expect to see local equities come out top the pile. On the flip side if the vaccines prove to be ineffective then we could see a total risk-off approach and then offshore cash may top the pile. The only thing for certain is that local cash won’t be top of the pile – it never has been the best asset class in any given year, although it is the least volatile so still a handy asset class to consider.
We often get told “don’t put all your eggs in one basket”. This proverb originally was used in the novel Don Quixote and effectively the motto is to not risk everything on one outcome. I suppose to explain the risk of eggs in one basket is to consider that if you dropped the basket, you could end up with no eggs and no asset i.e. you lose everything. This risk strategy is as critical in the investment world.
We already have shown that asset classes all perform differently through economic events, many of which are unpredictable. In the last five years we have had Brexit, Trump election and Covid – all of which were not predicted. The canny investor would be one that had a portfolio that could weather the storm created by these events and at the same time take advantage of the periods of growth in between.
A well-constructed portfolio will have a large exposure to equities as these are your growth engine for the long term. Companies that you invest in have the ability to adjust their selling prices in response to inflation meaning that their earnings, and thus their share price, tend to counter the effects of rising inflation.
A well-constructed portfolio needs a decent exposure to offshore assets. South Africa is a very small contributor to global GDP and the JSE represents less than 1% of global market capitalisation. Why would you limit your investments only to a small portion of what is available? There are several industries that do not exist in South Africa and that one can only access through offshore markets – many of the fourth industrial revolution companies do not exist here. Investing offshore also diversifies away from single country risk and currency risk. If the politicians in South Africa continue to make investor’s lives difficult locally the assets based offshore will be unaffected.
A well-constructed portfolio needs some exposure to bonds. Bonds are negatively correlated to equities and often hold up during a stock market crash. They will underperform over the long term as their coupon rate (interest) is often fixed for the duration of the bond life, and usually issued at a rate slightly above cash.
Blending different asset classes often delivers a return that is greater than the returns of the individual components. In this chart we have plotted the cumulative returns for 20 years of the JSE All Share Index (equities) in red and the JSE All Bond Index (bonds) in green. Added to this we have added a portfolio of 60% equities and 40% bonds, rebalanced to that weighting every month. This portfolio is represented by the blue line.
To use 20 years of information may seem like a long investment period but it is important to bear in mind that most investors will be investing for a period in excess of 40 years just by saving for retirement. During your investment life cycle you can expect to see between three and four stock market crashes but over time markets correct and if we look at the graph of the stock market index, it usually starts at the bottom left hand corner and ends up at the top right hand side with many up and downs in between. The long-term trend is always up.
There are many investors kicking themselves for missing out on a double-digit month in equities. They got caught by not being exposed to the correct asset class at the correct time. We are always big advocates of diversification while taking into account the risk profile and investment objective of each investor meaning that each of us has a unique optimal asset allocation, suited to our own requirements. We are happy to create your own diversified portfolio with optimal asset allocation suited to your risk profile.
If we can leave you with just one quote on diversification it is that famous one attributed to Nobel Prize laureate Harry Markowitz who said that “diversification is the only free lunch in finance.” Who doesn’t like things for free?