What’s your downside?

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By Mark Seymour

When it comes to making an investment, the obvious objective is to generate a return such that your capital doesn’t diminish in value (preferably a return greater than the prevailing rate of inflation).

The question is: What rate of return should you target? In order to answer it, the individual’s financial well-being needs to be assessed, his attitude towards investment risk needs to be quantified, his income requirements need to be taken into account and his investment goals must be considered.

In today’s “Angle” I take a look at a small aspect relating to the individual’s attitude towards risk. As we know , risk is notoriously difficult to quantify, not to mention the difficulty in conveying the implication of the actual “numbers” to your client. Some investment managers perhaps over-complicate their take on risk whereby every conceivable measure relating to risk can be found on their fund fact sheets (Information ratio, Sortino ratio, upside/downside beta, rolling standard deviation, tracking error, etc). On the other hand, risk (as Dave Foord once succinctly put it during a presentation) is “the risk of losing money”. Getting back to the first sentence in this paragraph, Dave’s point makes a lot of sense in gaining an insight into the individual’s attitude towards risk, especially during volatile market conditions such as we are currently experiencing.

When markets are volatile the value of your investment goes up and down, and you quite rightly feel you have “lost money” when the market takes a dip. For today’s exercise I analyse the market’s returns in terms of the “draw-downs” that have taken place historically. A draw-down is the percentage a price drops from a previous peak. For instance, on 11 October last year the All Share Index closed at a peak of 31,531.05 and subsequently dropped to a low of 25,135.13 on 23 Jan 08, representing a draw-down of 20.3%. If you liquidated your investment on the 23rd you would have “lost 20.3% of your money” relative to the amount of capital you had invested on 11 October 2007.

To answer the opening question “What’s your downside?” I’ve taken the liberty of analysing historical returns for asset allocations typically associated with the weightings for funds in the Domestic AA Prudential Medium Equity sector. As per the Association of Collective Investments as at 31 December 2007, the single managed fund’s weighting to the asset classes was as follows: Equity 56%, Property 2%, Bonds 21%, Cash 10%, Offshore 11%.

Applying these weightings to the historical returns of the different asset classes yields the following data: Since Jan 1926 your investment would have yielded an absolute annualised return of 12.9%, which would have displayed an annualised volatility of 11.3% (which means that for the most part your annual returns would have fluctuated between 1.6% and 24.2%). Your investment would have delivered an annualised real return of 6.5%; however, over a rolling three year period the real returns would have fluctuated between -10% and 25%, highlighting the need to stick to a particular investment strategy over the long term.

Finally, exposure to the fixed weightings in asset classes as listed above would have resulted in the following draw-downs:

7-april-aam1f.jpg

Source: I-Net Bridge and www.globalfinancialdata.com

From the above graph, we come to appreciate that even for a medium-risk investment, the potential for capital loss is prevalent, with draw-downs of between -10% and -25% being quite possible. In addition, it is sobering to know that the recovery periods from such draw-downs can typically range from 1 to 5 years.

Given this, it may be appropriate to reassess your investment options to ensure that your expectations of investment returns are not once again severely challenged when the market takes its next turn for the worse.

Source: Mark Seymour, Alphen Asset Management, April 7, 2008.

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