Is your investment worth the risk?

I’m sure that most readers are familiar with the term “danger pay”. 

For many years, it was a term that was associated mainly with soldiers that had to do service in very dangerous areas. 

These days it can even include extra insurance benefits against events like kidnappings for families whose occupations require them to relocate to areas where such a risk is high. 

Whatever the package, danger pay essentially refers to extra benefits or compensation for people who, among other things, are risking their lives to work in dangerous areas. 

Many may find these ‘benefits’ extremely attractive, but it is crucial that whoever considers them, is well aware of the associated dangers. 

In many cases, workers have to be willing to pay with their lives in exchange for a few extra thousand rand per month. 

In the investment world, we are also familiar with danger pay, or risk premium. 

It won’t necessarily claim your life, but it’s definitely something you should be aware of at all times, especially when compiling your personal investment portfolio.

Briefly, risk premium refers to the percentage by which, for example, shares must outpace risk-free investments to make it worthwhile for investors to invest in more ‘dangerous areas’. 

Many reports detailing several different methods to calculate risk premium have been released over the years, but I have found that many of them are way too technical. 

For me, the simplest way to calculate risk premium is to look at the difference in annual returns between shares and money market rates respectively.

Schalk Graph

Graph: FTSE/JSE All Share Index % minus money market % (source: Iress)

Investors would have earned 4.6% more by investing in shares (excluding dividends and before taxes) over the last 20 years than they would have earned if they had invested their capital virtually risk-free in the money market. 

This means that investors require shares to grow by at least 5% more than risk-free investments to make a share investment worthwhile. 

The graph above clearly shows that investors have had a really rough time over the last three years, with the difference regularly being negative. 

At -7%, the current rate means that shares not only performed worse than the money market over the last 12 months, but investors experienced overall negative growth. 

So how do we go about fixing this? 

If there was some way we could know that shares would outperform money market rates over the next year, the answer would be simple. 

But the reality is that no one knows. The second-best option would be to look at South African analysts’ general growth forecasts for South African companies. 

Thomson Reuters’ consensus forecasts give us a very good indication of analysts’ expectations for growth in shares. 

When we look at their forecasts for the growth of individual shares in the FTSE/JSE All Share Index, we will see that their expected weighted average growth now stands at 21.4% for the next 12 months, which is quite amazing. 

With money market rates currently trading at around 7.3%, it means that to make higher-risk investments such as shares a worthwhile option for investors, they must grow by at least 13% per year. 

If these analysts are correct, local shares should deliver about 14% more growth (excluding taxes) than money market rates over the next 12 months. 

Out of the top 40 shares, analysts have identified 12 companies for which growth in excess of 21.4% is expected for the next year. 

Out of these 12 companies, the most prominent are British American Tobacco Co., Naspers* and MediClinic. 

A word of warning to investors, however: Please handle this market with extreme care. 

The payment may appear to be worth the risk for now, but the dangers may still be around for some time to come. 

*finweek is a publication of Media24, a subsidiary of Naspers.

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