Latest / Ghost Stories / Ghost Stories #107: The real risk is playing it safe

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Ghost Stories #107: The real risk is playing it safe · Ghost Stories

• 0:00
  Speaker A: This episode of Ghost Stories is brought to you by Satrix, the leading provider of index tracking solutions in South Africa and a proud partner of ghostmail. With no minimums and easy low cost access to local and global products via the Satrix now online investment platform, everyone can own the market. Visit Satrix Co Za for more information. Welcome to the Ghost Stories podcast and I'm looking forward to speaking to Kinsley Williams today. He is the CIO at Satrix. He is certainly no stranger to the ghost mail audience. We've spoken to Kinsley many times before on Ghost Stories podcasts, but today we are going to talk about the risk of playing it safe. Isn't that a fun topic? And that's because volatility is what we feel every day in the markets and certainly the first part of this year would definitely fall into that category of being volatile. The reality is that over the long term, it's actually inflation that hurts us, not so much the volatility. So Kinsley, thank you for joining me to talk about what I think is quite a tough mindset shift for investors, actually, as they learn to deal with market volatility. I think you're going to really give us some excellent and context to just how important this stuff is long term.
• 1:06
  Speaker B: Yeah, really great to be speaking to you again, Ghost. And it's very, very important that we keep in mind what we're ultimately investing for, whether that be retirement, your kids, university, education, whatever that long term goal might be. Investing in my mind is inherently a long term endeavor as opposed to saving, which typically has a shorter term horizon. Investing is also inherently a risky endeavor if the objective is to grow your capital in excess of inflation. If that isn't your objective, all you're doing is saving and trying to keep pace with inflation. In other words, having the same purchasing power tomorrow, next year, et cetera, as you would have today. So I think it's important to frame what we mean by investing and some of the assumptions that underpin that.
• 1:54
  Speaker A: Yeah, absolutely. I mean, one of the statements that you made to me in the prep for this podcast is that the greatest risk is not taking any risk. And that's such a powerful statement that I think it really does deserve to be unpacked properly. So I'm keen for you to walk us through exactly what you mean by that, especially for investors who do tend to be cautious and put their money in money market accounts, even when that investor is quite young and maybe they actually have enough in the way of emergency savings. You've already alluded to the importance of saving versus investing. These are two different things. But I think there are a lot of people who over save and underinvest is perhaps the best way I can describe it.
• 2:30
  Speaker B: One of the key concepts, the simple but most profound concept that I learned when I was doing my investment studies is that of investment term. This concept was clarified when I was actually doing some elective units at the University of Chicago Booth School of Business. Just as an aside, how do you know someone has an mba? They're going to tell you, right? They're going to tell you. Just to be clear, I didn't study full time at that university or graduate there, but I did have the very fortunate opportunity to spend three months on an exchange program through WITS Business School, which is where I did my mba. University of Chicago Booth School of Business is the top finance school in the world. It was when I did it. I'm sure it's still right up there. There are many Nobel laureates that have their professorship there, et cetera. Phenomenal opportunity for anyone wanting to get exposure to that side of the world. I digress a little bit. But you touched on it at the beginning in terms of how we often look at volatility or standard deviation or variance as our primary measure of risk. And I think that's because it's a relatively easy to quantify and understand measure. It's a measure of the bumpiness of the ride, but it doesn't really tell you what investors probably care more about. And that's ultimately the risk of loss. And we can talk more about that. There's another key risk as well, which is the opportunity cost risk, which is not taking enough well rewarded risks. I'll come back to those two key risks which I think is what investors should probably think more about rather than volatility in and of itself. So one of the things to recognize with investing is that it is very difficult to quantify what the actual return for a particular asset class may be over a given period. There's a lot of estimation risk associated with that are equity is going to go up 5%, 10%, 15%, 20%, 25% over the next 12 months or even deliver a negative return. Like yes to all of the above and in no particular order. Right. Like any one of those outcomes could potentially happen because there's some known variables that could drive what that return outcome could be. But there are also a lot of unknown or unpredictable variables that also influence that final return. And even with those known variables that are going to drive what an equity return is over a Medium to long term period. There are a lot of unknown events that could affect those known variables. So it's a lot of unknown unknowns that can ultimately influence your long term return. So how on earth does one end up deciding what to invest in? Well, an interesting thing happens when you start expanding your time horizon because you start getting a little bit more certainty around what is more likely to transpire than when you look over a relatively short period, even over 12 months. One of the other things that we do when we do this exercise of looking at asset class returns is you could look at a long period, say like 10 years. But we don't just pick one period because in that one 10 year period there would have been a lot of macro and geopolitical factors at play that would have influenced the returns for that particular 10 year period. So you want to look at lots of 10 year periods, all of the 10 year periods over a longer horizon, say over a 20 year period or 25 year period, then you start getting an indication of what the average return is over all 10 year periods over that 25 year period. And you could even argue that even that 25 year period is not really long enough, because even that 25 year period is going to be shaped by macroeconomic and geopolitical phenomena that shape the returns of various asset classes over that time frame. The reality is you start running into the accessibility of data and comparability of different asset classes. We've gone back about 25 years, but you could very much make the argument that that's not even long enough. You start getting what becomes more typical for the different asset classes even over that period. Because it's corroborated by other research that other academics have done over the centuries even, which shows that basically equities are going to be your best performing asset class over the long term. Let's just delve in a little bit to what we see over a shorter period. If you hold a particular asset class like local equities. So even over a 25 year period. So while that's relatively short, if you think about your total investment journey might only be half of the period of time that you're saving for. Let's say you have a 40 year period of time that you're investing for. Even though while 25 years is relatively short, we have experienced some significant market events over that period, like the dot com crash, the global financial crisis, and obviously more recently the COVID lockdown, how markets responded to that. There've been lots of other market regimes historically that wouldn't be in that 25 year investment horizon. But there have been enough shocks to the system for us to stress test what is likely to happen should we have the next shock, what whatever that might be. What we see is that the longer you hold a particular asset class for for example, local equities, the risk of capital loss starts to decline. So for example, if we look at all rolling three year periods, local nominal bonds have not experienced any capital loss on a total return basis. In other words, that means by reinvesting your coupon income, while for local equities you have on average lost between 5 to 10% of your capital 5% of the time. So 95% of the time you've made a gain. But for 5% of the time, if you look at all rolling three year periods, you run the risk of losing somewhere between 5 to 10% of your capital on a three year holding period basis. When you start looking at that data, you quickly recognize that you probably need to be holding local equities for at least a 10 year period to be assured, assuming history repeats itself, that you're never going to lose capital. Because that's certainly been the case. If we look at the historical data, you haven't lost any money. If you've been holding local equities on a total return basis for a 10 year period, the risk of capital loss is zero. That's certainly what has transpired historically over that 25 year period. The question that we then need to be answering is why would I hold equities if bonds are that much safer? And I think this speaks very much to that second risk, that opportunity cost risk. Let's expand our horizon to say 10 year periods. And we look at all rolling 10 year periods. Local nominal bonds have delivered on average an approximately 9% return per annum, whereas local equities have delivered on average a roughly 12% return per annum. So a whole 3% more than what nominal bonds have done. So both have outperformed inflation, which is great, but there is a real opportunity cost there of not taking additional risk in equities if you have time on your side. So if you have a 10 year investment horizon, why would you care how bumpy the journey is? Because if you're going to take a smoother, safer route, that's ultimately going to cost you 3% per annum, your listeners should all be very aware of that eighth wonder of the world that's often attributed to Einstein of compounding. Basically, he said that those who understand compounding earn it, while those who don't pay it and it's obviously in dispute whether he actually said it. I'm sure it's accredited to him to add gravitas to the point. Whether he did or didn't say it is up for debate. But the point is it's no less powerful. Right? You want to take advantage of that 3% per annum compounding because over a 10 year period that results in a massive difference in finance final value, which is ultimately what you're solving for. So if you're investing for the long term, you want to make sure you maximize the potential return because the bumpiness that you incur along the way is almost a moot point if you know that with a high degree of probability you're going to lock in a materially higher return over that time horizon.
• 9:41
  Speaker A: That couple of hundred basis points excess is how careers are made and lost when it comes to active asset management, right? So it makes a big difference. I mean, the difference between the rockstar fund manager and just another normal sort of average fund manager can literally be 100 or 200 basis points over a long time. That makes someone a household name, quite literally. So the compounding makes an enormous difference. You've talked about the bumpy ride a few times. It's like if you're going on this dream trip, you're going on this around the world story. A little bit of bumpiness on the plane doesn't detract from how wonderful the end result is. If you're maybe going on a short drive around the corner to the shops, you're going to be irritated by something wrong with your car and it's very bumpy. But if you're going on this big, long term, exciting journey, then you'll be willing to have some of the turbulence. And that's what investing is, the big around the world trip. That's basically how important it is and how big the reward is if you get it right. The other thing that you've raised there, which I think is important, is that yes, we have these market crashes, we have these issues that come through, but again, if you look over these 10 year periods, you let these cycles play out. Ironically, if you're early in your career, you actually want markets to crash so that you can buy more at relatively cheap prices. Technically speaking, that's what you want. What you don't want is to be investing into really hot markets. That's the big mistake that people make, right, is they don't necessarily up their investing if they can when things are hard. We've seen some of that now with some of the big tech names, et cetera, off 20, 25, 30% or more. That's the time actually. Not just blindly do the research, etc. Etc. But it's the old story. When everyone else is scared of the market, that's the time to be thinking about upping your allocation 100%.
• 11:15
  Speaker B: Investing is very much, as I mentioned at the beginning, it has risk intrinsic to it. These market corrections crises that happen from time to time, and even if we want to use the word bubbles, which happen from time to time, are features of investing. You were chatting to one of my colleagues this week as well and talking about that very point.
• 11:33
  Speaker A: I was about to say Niko is going to shout at you for using the word bubble.
• 11:37
  Speaker B: Yeah, yeah. The exuberance that we see in certain sectors of the market at different times is actually what encourages the investment into those speculative new generation technologies, for example, which makes it attractive. That avails the capital to make investing in these new technologies worthwhile. If there wasn't that excitement, no one would invest in it because it wouldn't have the potential upside returns that are promised. But yeah, does the market get greedy and get ahead of itself? Sure. Is there excess fear which results in a sharp correction? That also happens. And these are well known features. But what you have on your side is time. And as you give time to the equation, those bumps along the road actually become distant memories. And yes, as painful as they are when you experience them in the moment, it's amazing how quickly we forget. And as the market recovers, it reaches new highs because that's what it's meant to do. It's not a bug when you have corrections or bubbles, they're more of a feature.
• 12:29
  Speaker A: Yeah, absolutely. And the other thing that's a feature is inflation. Right. And we're seeing it come through now from listed companies, seeing it more and more and more in the sense announcements that I read every day. Inflation is here. This oil price spike is going to drive inflation throughout the system. And obviously inflation, like any other macroeconomic concept, has cycles. So there are times of higher inflation, there are times of lower inflation. And so you've got to then distinguish between, well, what am I investing in very long term? Then maybe you don't care too much about where we are in an inflation cycle. Those who maybe have more of a medium term view will need to think carefully about that. What would be, if I can call it the Ron exposure to have too much of. In an environment where you've got higher inflation, you've maybe got interest rates that are Going to be higher for longer as well. What would be the classic mistakes that people would be making in that environment?
• 13:17
  Speaker B: Markets will adjust to the inflation level at any given point in time, whether it's low, medium or high. But what I would say is one of the biggest risks for safer investments, particularly bonds, is actually inflation, but specifically inflation surprises. So it's the change in inflation because the bonds will be priced on an assumption of what inflation is likely to be over whatever investment horizon you're looking at, whatever the duration of those bonds are that you're holding. But if the inflation dynamics change and those assumptions are now no longer valid, in other words, you face an inflation surprise. That's where bonds are super sensitive. This is also where you can get quite hurt by playing it safe. In an asset class that is supposedly safe, like bonds, if there's a subsequent shock and surprise to that, that's where you can get really hurt, because those bonds are going to recalibrate. There are other factors that affect bonds like default risk and credit rating, ability to meet future payments, etc. But inflation's the big one, particularly for government debt, which is less exposed to that default risk. But to answer your question as well, equities are a great long term hedge for inflation because if you think about it, companies will ultimately pass on inflationary increases to their customers. So as long as the business remains viable and it can compete within its industry and its sector, they're going to be hedging against inflation by passing on those increases to counteract the effect of inflation on their costs, revenue and profitability. Higher for longer inflation is therefore not a problem per se. Obviously it does generally correspond with a higher risk free capital rate, which affects equity valuations. But I think the bigger risk is an inflation surprise, as that upsets the real return expectations. Businesses can adjust if they have a common understanding of what the expectations for inflation are likely to be, because that gets baked into the system and they price accordingly within equities. At Satrix, we tend not to make calls on different sectors as there are a lot more variables within a particular sector to now consider one sector versus another and therefore more known and unknown surprises to those expectations. So we rather look at broad asset classes in terms of where we want to position our portfolios, particularly our balanced funds. But if we come back to real returns, so in other words, returns in excess of inflation, this is ultimately why we invest, right? That's what we're trying to solve for. We want to deliver a return in excess of inflation, and it's important for Investors not to lose sight of that when looking at their returns longer term. It's the return in excess of inflation and giving appropriate time for that investment to appreciate in excess of inflation, which is ultimately what investors should be solving for and why they invest in the first place, not to protect capital or merely keep pace with inflation. And the key ingredient that unlocks that is the appropriate amount of time in relation to the asset class that you're investing with. Equities are a great long term hedge against inflationary effects for the reasons that I mentioned earlier. But beware, while bonds appear safe, inflation is the big Achilles heel that can trip them up. So you can play it safe, but actually you can have a big risk if there is an inflation shock to the system like we're experiencing at the moment.
• 16:20
  Speaker A: Kinsey, you've raised a lot of important risks there around bond investing. And I always remind people that it's called fixed income, not fixed returns. Two very, very different things. You're not going to get a fixed return from a bond because the traded value can and will move around based on the income it's paying and relation to what's going on from a macroeconomic perspective. So always something important to keep in mind. We've talked a lot about how time in the market is really important. The old story, you get a good return from equities by hanging around for a long time, but if you're not diversified, then that may not hold true. So it is very important to make sure that you are playing the game from a diversification perspective. Because if you're going to go and own two or three or four different stocks, or you go and own 20 stocks with exactly the same underlying fundamentals, then that's not diversification. And there is no guarantee whatsoever that you will do well, or that you will make excess returns or anything of the sort. Then obviously ETFs like the ones offered by Satrix do make that a lot easier. But what makes it a lot harder is that global indices are not as diversified as we might like. If you are buying market cap weighted index, you're not necessarily getting that diversification because of the way the world has gone where so much value is now concentrated in a relatively small pool of companies and sectors like tech, for example. So how do investors actually go about addressing that risk and making sure that they're not falling foul of the need to diversify?
• 17:43
  Speaker B: Completely agree with your points there. And the importance of diversification. Very important to take well rewarded equity risk over an appropriate time horizon. And as you've Already mentioned, it must be well diversified. And the reason why is you want to minimize what we call idiosyncratic or company specific risk and avoid losing all of your capital or having it written down significantly, which can easily happen with a particular company. It can face some scandal or some controversy or some unknown risk that literally can result in that company no longer existing and your investment becoming completely worthless. So that's why you want to diversify. It doesn't diversify all your risk away, but it removes close to zero your idiosyncratic or company specific risk. If you know well diversified, however, diversification is not as straightforward a thing because lots of companies in and of themselves may end up being less diversified. In an extreme case, for example, you could hold lots of companies in a portfolio, but they might all operate in a single sector or geography or have a big concentration around that. Whereas it's possible to have a portfolio with a few companies in it that are themselves very well diversified. I think different business lines, geographical exposures in which they operate, or different types of assets and business models that they generate revenue from. So that helps to diversify your mix. That's why I say it's not so straightforward to think about. If you think about what you're investing in when holding a broad basket of companies, you're actually investing in the future revenue streams of all those companies, as well as any innovation they devise to overcome the challenges a particular business or industry is facing. And let's make no mistake, there is a lot of pressure to find those solutions as remuneration incentives for employees, and particularly executives, is a big motivator, or not receiving those remuneration incentives is a big motivator. Or in a worst case scenario, actually losing your very livelihood in your job because the business has to restructure or downsize, the staff's jobs may be on the lines if they haven't delivered. Coming to your point around market cap weighting, that's a very interesting one, because ultimately, if we think about what a market cap weighted index represents, it's the sum total of what all investors in the market are holding in aggregate. For every investor that's overweight a particular company, there must be another investor or investors who are underweight that company, with the neutral position being the market cap weighted index. So when you think of a market cap weighted index, it is the sum total of what all investors collectively hold. You could have extremely concentrated portfolios on the one end of that distribution and then extremely diversified, or where you've solved for some other measure of concentration. On the other end, the market cap portfolio is the ultimate representation of what all investors hold in aggregate. So talking about equal weighting, for example, as a way to diversify, there's quite an extreme contrarian position to take because it says regardless of where the collective wisdom of all investors is centered, which is the market cap weight index or portfolio, it ignores that and down weights the largest companies to 1 over n if they're in portfolios in the universe. Take an MSCI world. There's 1,300 of them, give or take. You're only going to hold 1 1,300 of each company in your portfolio. And similarly, you're going to upweight all the smaller companies that might have a very minuscule weight, also 1 over 1,300. So you're going to be big upweight on the small and massive downweight on the largest companies. So it's quite an aggressive way to tackle the diversification problem. And you could end up with a portfolio that has significant tilts from a geographical and a sector perspective that looks very different to the market cap weighted portfolio, which as I mentioned earlier, is the aggregate of what all investors are holding, that is ultimately the representation of what the universe looks like at the midpoint. Equal weighting, for example, as a solution to that diversification problem also has some some pretty practical implications as well, such as liquidity. You're now having to significantly upweight smaller companies as well as trading costs, because now every time you rebalance that portfolio, you're going to have to trade against market movements to bring everything back into a 1N weight to keep that portfolio equally weighted. To conclude on this point, if you're trying to solve for risk, it's better to be explicit about which risk you're trying to solve for. For example, sector exposure or geographical exposure, or largest company weight or overall volatility. Those would be measures of risk and solve for those explicitly because when you solve for that, there is always going to be some unintended consequence. Solve one problem, but you might introduce another into the portfolio. Diversification is an easy thing to talk about, not necessarily the most obvious thing to solve for. You might be solving that risk, but introducing many other unintended risks in the process.
• 22:28
  Speaker A: Fantastic. Lots of great stuff for people to think about there, all those smart choices, et cetera. But the one thing we haven't talked about is, is there is a way to do it in South Africa that gives you an additional benefit which really then tilts it in the favor of equities. In my opinion, that is of Course, the tax free savings account, which has become a more and more popular tool for South Africans. I personally use it with a nice heavy tilt towards property ETFs because then I get a nice tax free dividend and I get the capital gain that comes from having these portfolios in South Africa, which works really well. What do you do with yours, Kinsley? Because I don't doubt that you are a tax free savings man who maxes his art every year. Where does it go? What sort of equities do you buy? Or do you just give it a nice spread?
• 23:08
  Speaker B: Great points there. There's only two certainties in life, right? Death and taxes. But in this case you can avoid one of them. So you definitely want to be taking advantage of any opportunities to reduce your overall tax effect on your savings. If we're talking about investing, there's two big factors that erode your outcome. From an investment return perspective, tax is a huge one. So if you can ensure that your investments are not being subjected to tax by investing in tax efficient vehicles like tax free savings or reinvestments, and similarly RAs as well, which also have tax benefits, retirement annuities, those are no brainers to take advantage of. The other big erosion of return is costs, and obviously Satrix has very much been at the forefront of reducing that for investors. When looking at what to invest in, particularly within a tax free investment wrapper, let's go back to the beginning. To quote the Sound of Music, that's always a good place to start. What you want to be thinking about is which index or asset class offers the best long term return. First and foremost, that's what you want to be solving for. And then do that in a tax efficient way because you're going to be subjected to tax on all types of investments. So while REITs, for example, like listed property, which you mentioned, would have a big tax advantage from a dividend or an income perspective because they are high yielding type investments you ultimately want to be solving for. Your total return and equities also have tax implications on a dividend perspective and on a capital basis. So within a tax free savings vehicle you avoid the implications of capital gains and dividends withholding tax, which also cause a drag on your returns. So I think you want to go back to the beginning and say I'm ultimately trying to solve for maximizing my return over a particular term, hopefully 10 years plus. Therefore, how do I get the best investment over that horizon and invest in that? That's the way I would think about tax free investments, making sure I'M exposed to asset classes that are going to give me the best long term return. If you solve just for the tax implications on a yield basis, for example, you may end up solving for the wrong thing because you're now getting a big tax kick on bonds for example, which is subject to income tax which you would now not be paying in a tax free investment wrapper. But you're ultimately still in a 3% less return over a long term period than what equities would give you. You're solving for tax efficiency without solving for the long term investment outcome.
• 25:24
  Speaker A: Thank you Kinsley. Lots of great insights there. Always appreciate your time. To those who want to engage with you, go and Find Kinsley on LinkedIn. Chat to him there. Go back and look at some of the other podcasts that I've done with Kinsley as well. There have been a number of them and they are all interesting. Kenzie thank you.
• 25:37
  Speaker B: Thank you very much. Ghost. Always great chatting to you.
• 25:40
  Speaker A: Satrix Investments Pty Ltd and Satrix Managers RF Pty Ltd. Are authorized financial services providers. Nothing you have heard in this podcast should be construed as advice. Please do your own research and visit the Satrix website for more information on all their ETF products.