How to invest in risky markets

2012-07-07 10:22

Every time we open a newspaper, listen to the radio or watch TV, we are inundated with information on the imminent collapse of Europe and the impact it will have on global growth.

As a result, stock markets across the world are extremely volatile and share prices are rising and falling by significant amounts every week.

Investors are understandably asking whether now is really the time to invest their money.

We know that to outperform inflation over the longer term we need to invest in so-called “growth assets”, which include equities (shares in companies) and property.

But these investments can fall in value, especially in uncertain times.

Yet, if you take a longer-term view, then sitting on cash waiting for the “right time” to invest is also not a solution.

If experience shows us anything it’s that it is almost impossible to guess the “right time” to invest.

The chief investment officer of Novare Investments, Francois Cilliers, says: “Where a lump sum is concerned, timing the market is often a fickle exercise, even for investment professionals.”

So what is the best investment strategy?

The power of the debit order
One of the best ways to save is through a monthly debit order, as it reduces the risk of investing at the peak of the market.

With a debit order you buy shares on a monthly basis, which averages out the price you pay for those shares over time.

When the market falls you are able to buy more shares, or units in a unit trust, for the same amount of money, which is a lot like shopping during sales.

In fact, it is better to invest when the markets are falling – if you are saving using a debit order and you hear the markets have fallen, you have reason to celebrate because your money is buying more shares!

When markets rise shares get more expensive, but over time markets always rise, which is beneficial for growing the lump sum you accumulate through your monthly investment.

Your time horizon
Before you invest you need to decide when you will need the money.

The head of retail business at Prescient, Nicky Gous, says: “Equity market cycles tend to last between five and eight years. Investors with a long time horizon (10 years or more) would typically be able to take more risks, as they are able to stomach more short-term volatility. There is more time to recover from short-term losses.”

But if time periods are too short to allow the investment to recover, “the return of capital trumps the return on capital,” says Paul Stewart, the executive director and head of asset management at Grindrod Asset Management.

This means that over shorter periods you should avoid assets that can fall in price and rather consider investing in cash or bonds.

You can save for the next 10 years
Stewart says that over this longer period you should invest in a portfolio with 70% to 80% in high-quality local and global equity and listed property with a special focus on emerging markets.

Fund managers expect emerging markets to drive economic growth in the future.

They also believe there is more value in the overseas markets than locally, so having a fund with exposure to global markets would be an advantage.

Stewart says the remaining 20% to 30% should be invested in cash, government and company bonds, as well as a small allocation to gold for diversification reasons.

A high-equity prudential unit trust would meet these requirements.

Five-year investment horizon
Gous says investors with a shorter time horizon, of say five years, have a bigger challenge to generate real returns.

“The full equity market cycle may last longer than the investor’s time horizon. The management of downside volatility now becomes more important because the investor won’t have time to recover
from a large drawdown,” says Gous.

But she adds that exposure to growth assets such as equity is still important, as you can’t afford to fall behind inflation.

Gous says that to have exposure to equities but limit your risks it is a good idea to diversify across different asset classes – including equity, bonds, cash, property and offshore investments – as this will result in steadier returns.

A medium-equity balanced fund would meet this requirement.

For example, the Prescient Balanced QuantPlus Fund holds a mix of assets, having enough growth assets (South African and African equity) at attractive valuations to deliver inflation-beating returns, while having allocations to offshore, gold and equity protection structures in place to manage the downside.

Stewart says for a lump-sum investment with a five-year view, one should select an investment with 50% to 60% in high-quality local and global equity and listed property.

The remaining 40% to 50% would be invested in lower-risk, interest-generating assets, as well as a small holding in gold.

Gous says given the low interest rate environment, this portion of the fund should invest in low-risk investments that can offer interest rates (yields) higher than cash.

This would include inflation-linked bonds, floating-rate notes and credit-linked notes, which would provide a better prospect to generate returns above inflation.

Gous says for a risk-averse investor who does not want to lose capital but still needs equity exposure, diversification alone is not sufficient for managing risk. Some alternative investment strategies aim to address this, such as positive return funds.

According to Gous, these funds make effective use of derivatives and follow a dynamic process to try to protect capital over a 12-month rolling basis while providing positive real (after inflation) returns over time. (Next week we will take a closer look at hedge funds that aim to protect your capital.)

Two-year investment horizon
Gous says an investor with a short time horizon of about two years would generally be more risk averse.

“Any volatility or negative returns could significantly impair their ability to achieve investment goals,” says Gous, who adds that an investor wants to limit risk and have more liquid assets over this time.

But because our current interest rates are actually lower than our inflation rate (5.5% from cash versus an inflation rate of 5.7% to 6%), there is a real chance that the value of your investment could fall behind inflation and will buy you less than it did when you started saving.

For a two-year lump sum investment, the RSA Retail Savings Bond offers a return of 7% a year. But your money is locked in over this period, although you could select the one-year RSA Retail Savings Bond and roll it over for a further year if required.

Alternatively you could invest in an income fund unit trust that is diversified across various financial instruments with the aim of delivering returns above inflation.

If you are investing for a year or less, then a money market fund or fixed deposit with your bank is the best option.

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