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Current
News Letter/s
Why
Balanced Portfolios work
We
often stress that the most important decision investors
will make is how they divide their investments between
the different asset classes. Not only will it affect your
return, it will also affect the volatility of your portfolio.
Think of volatility as a drunk trying to walk along a
straight line. Sometimes they veer to the left, sometimes
to the right. They may get to the end point but they would
have walked further than someone who just walked directly
to the end point. In investments that volatility, or deviation
of returns, costs.
Research
done by Nedgroup Investment compares the return over 20
years of two investments, one with low volatility, the
other with high volatility. The average annual returns
are the same, its just the volatility that is different.
Over 20 years the higher volatility investment will return
over 20% less than the investment with lower volatility.
Why?
A practical example will show why this is so.
It is harder to recover from a large decline than a small
one.
If I have R100 and it declined by 20% to R80 I need a
return of 25% to get back to R100.
If I have 10% decline I only need a return of 11.1% to
get back to R100. An increase of 1.1% is much easier to
get than 5%.
Volatility
is particularly important if one draws a regular income
from your capital, as most of our clients do.
It
is easier to recover from small declines in value than
from big declines. In big declines you are drawing down
on a larger percentage of your capital.
By
investing in a spread of investment types you can reduce
the volatility of your overall investment portfolio. Indeed,
there is the investment equivalent of a free lunch here,
as the decline in volatility is even more than we would
anticipate.
Nedgroup
Investments calculate that the volatility for a South
African portfolio of 60% equities and 40% bonds is 14%
p.a. Considerably less than the 21.6% p.a. you would expect
from an equity only portfolio.
They
then calculate the expected volatility of the following
portfolio:
45% SA Equity
15% overseas equity
30% SA bonds
10% overseas bonds
The
expected volatility drops to 11.6% p.a, a reduction of
9% p.a. compared to a pure equity portfolio. One of the
major reasons we believe in overseas diversification is
because it reduces risk. Investment research highlights
the benefit of balanced portfolios.
Investment
arithmetic supports it. So does human behavior.
Investors
who use balanced portfolios tend to change their investments
less frequently than those who don't. This gives the market
time to do its work.
We
know that in the long term equities outperform other asset
classes. We also know equity returns are extremely volatile.
By using a balanced approach rather than a timing approach
one ultimately derives the benefit of long term equity
returns. Research into actual investment returns shows
that investors in balanced portfolios do as well, if not
better, than those who hold only equity portfolios and
try to time the market.
In
South Africa we are fortunate that we have a number of
well managed balanced funds to choose from. As these funds
often represent the "house view" a good deal of attention
is paid to them by the management houses.
Brian
Goodall
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