Read on for some insight into risk, the consequences of holding onto cash, and a safe investment option in current times.
What is risk, exactly?
Investment risk can be defined as the probability of loss relative to the expected return from an investment. It’s a measure of the level of uncertainty. The reason investors should assume a degree of risk in their portfolios is that the returns on riskier investments are greater in the long-term. Equity and property investments carry more risk than cash and bonds.
Is cash really king?
Cash is regarded as king by many investors, as it’s the least risky asset class and the returns have been greater than those from local equity over the past five years. Cash does, however, bear inflationary risk in that if the inflation rate increases more than the interest rate, your money will have significantly less buying power in the future.
Some investors are still selling out of equity and investing in cash, and in doing so locking in their losses, instead of regarding the current figures as mere paper losses. Also, if you sell at a loss, you need to earn a higher than average return, to get back to the original value of your investment.
Another trouble with holding cash is that nobody knows when the tide will change, and it’s likely that you’ll not buy back into the equity market at the right time and may miss out on the next bullish run.
And last, you should always be aware of the tax implications of your investment selections. The interest from cash is taxed as income, and your marginal tax rate may be far higher than the dividend withholding rate of 20%, which would apply if you were holding equity. Also, the local income tax exemption of R23800 (and R34500 for those over the age of 65) hasn’t increased for the past five years, thus increasing your interest tax liability.
Remember that if you want to hold onto some cash, you can counteract this lack of adjustment by investing in a cash instrument in a tax-free savings account to the extent of R33 000 a year (with a lifetime limit of R500 000).
A word of warning
Some institutions in South Africa are offering fixed-term deposits with unusually high interest rates. I advise clients to do some research into the details and to speak to their advisers about how these interest rates are calculated and what the early-termination penalties are.
Investors should also be very wary of the term guaranteed. An institution that’s been around for 100 years offers a very different guarantee to a company that has been around for only five years. And while you should invest only in investments registered with the Financial Sector Conduct Authority, this doesn’t preclude the company from defaulting or losing your money.
Controlling risk is key to your investment strategy and the best way to manage risk is to diversify your investments across a variety of asset classes as they behave differently during the various market cycles.
A portfolio of wealth that includes assets that are negatively correlated (such as equity and cash) is less volatile and performs better over time. It’s critical for South Africans also to diversify offshore, as our economy represents less than 1% of global economic activity and the growth locally is relatively low.
Another way to reduce risk is by investing frequently and benefiting from rand cost averaging. When investing a fixed amount on a regular basis, one buys more units (of shares or unit trusts) when prices are low and fewer when prices are high. By doing this over a long period, you get a reduced average cost per unit over time.
A safe investment option
I regard multi-asset income unit trusts as a safe option in current times for those wishing to have low exposure to market volatility. These investments are usually comprised of a range of income-producing assets including cash and bonds. They also include some dividend-paying equity and a smaller percentage of property for growth.
Risk - like death and taxes - can never be entirely avoided. But by better understanding the nature of risk and the benefits of diversification, you can manage risk, and increase the probability of realising your financial goals. Knowledge is power, after all.
Janet Hugo is a director of Sterling Wealth and the Financial Planner of the Year 2018/19.