When you create an investment one of the first considerations is the topic of risk, which is usually stated as “I do not want to lose money”. This however presents a problem as capital risk is the risk of losing money on your initial investment amount, for example, if you invest R100 and it grows to R200 but subsequently loses 50% (R100) you will be back to R100 and will not have lost capital; you would not have made money at all but neither would you have lost any, or is this the case?
A better adjustment would be to increase your initial capital value by a pre-determined rate or inflation annually; over time inflation will erode the amount of goods that your Rands can buy so earning a rate of return under inflation is also a version of capital loss.
Secondly, when risk is referred to, what exactly is it that you as an investor should be concerned with? The aforementioned risk of capital loss certainly is a big concern however what about the risk of not outperforming inflation, not reaching the required growth rate used in the projections for your retirement calculations or the different risks faced when using active or passive (yes, who would of thought that risk was so extensive – daunting to say the least isn’t it?).
Keeping risk in mind is important, especially if you are going to place a lump sum of money into the market or withdraw a lump sum out. The main concern in this situation is referred to as sequence risk, which basically means that there is a difference between losing money in the beginning or at the end of your investment term and getting a nice consistent average return. The problem is that losing money in the beginning of your investment means your investment now has to make back the money off of a smaller amount (this principle is thought of as Siegel’s paradox), this is one of the reasons why your advisor would either ask you to add more money after a correction or to re- balance your portfolio. Let’s look at an example with two different hypothetical portfolios:
Each portfolio (portfolio A and portfolio B) made an average return over 4 years of 5% but with a difference, portfolio A had a large loss at the start of the investment.
Portfolio A therefore under-performed Portfolio B by R5.63 or, said otherwise, ended up with 4.86% more return. Even though the difference is small in the example above it illustrates the problem with sequence risk perfectly. This should be noted as the more returns you get to keep from your portfolio, the easier it makes it to reach your desired goals. One possible way to reduce the risk of downside losses initially is to consider phasing into the market, this will however not be discussed in this article.
There is one more aspect that we need to consider with sequences, this is what happens at the end of the investment? As your money gets larger in value small percentage changes can have large Rand value changes. Consider the following example:
20% gain on R100 000 = R20 000
2% Gain on R1 000 000 = R20 000
For this very reason you, as an investor, need to make sure that your investment is not too aggressive close to the end of your investment term (i.e. your retirement). It is important for one to make sure that your investment is structured properly at both the beginning and end of the investment term but be careful not to ‘tinker’ too much as more often than not making emotional changes to your investment may lead you to a worse off position.
Robert Starkey RFPTM, MIFM