Risky Business:
Throughout the ages, many have tried to put into words exactly what risk is and what it means to them. Some have been more successful than others—cutting to the heart of the matter, appealing to sensibility, or just putting an idea that’s difficult to explain into words we all can understand. Perhaps now is a good time to start understanding the difference between risk and volatility and what it means to you.
Should you be worried?
The recent devaluation of the rand, labour disputes in the mining and agricultural sectors as well as concerns about our economic future are unsettling investors in SA. The fact that the stock market performed very well recently is amplifying the fear as investors worry that the market cannot continue going up for much longer. Should you be worrying about this too? More to the point, what should really worry you – uncertainty, volatility or inflation?
Volatility is not risk
Reading marketing material from fund managers who brag about the low volatility of their funds as if this means that their funds are somehow less risky than their competitors is, arguably, a pointless exercise. One cannot equate volatility with risk, especially if you are a private individual who needs to make smart, long-term investment decisions. If you are trying to generate real capital growth, you should be praying for volatility. Investments with no volatility are either very low risk and stand little chance of beating inflation, or they are Ponzi schemes that promise both stellar growth with low volatility (which is just too good to be true).
The opportunity of uncertainty
Where would you rather invest your money today: in platinum miners or the listed property sector? A large number of people would prefer listed property. The returns have been great and there is a good chance that these companies will generate income and profit in the next few years. What about platinum? Well, the unions seem hell-bent on destroying their source of employment in a lethal game of chicken to get higher wages for a reducing number of employees. Some platinum miners are even being publicly targeted by government – never a good sign for investors.
However, savvy investors (not of a nervous disposition) would seriously consider the platinum miners rather than listed property or the retailers in SA. There is good value in platinum miners and they have no international competition so they have a natural monopoly. The uncertainty facing the sector is precisely what creates the investment opportunity and hence the potential (this is not advice but merely an example of character).
Manage the rollercoaster
Most international markets, including SA, have performed very well recently. So volatility has reduced and most equity investors are in a comfort zone. This is probably a good time to start worrying; complacency with equity investments is never healthy. The probability that equity markets will generate reduced performance in the years ahead is increasing constantly. It is going to be difficult for most asset classes to beat inflation in the next three to five years.
So, should you sell out of equities? Definitely not, however it would be a good idea to diversify your portfolio across a range of sectors and asset classes. No one knows if the stock markets will continue to run for the next year or three and the savvy investor would prefer to earn dividends rather than interest on cash. The only effective strategy for man-aging your assets in volatile conditions is to be optimally diversified. The best investors never invest with absolute conviction because they realise that the stock market will always do the unexpected in the short term. This means they don’t bet the house on one particular strategy.
Smart investors will allocate some capital to one strategy but if they are wrong, they will have capital allocated to other strategies too so that they do not take unsustainable losses. Absolute conviction with investments is always fatal to capital growth.
Inflation is the real enemy
Over long periods of time, your real concern should be about the effect of inflation on your money. If you do not invest in productive assets like shares and commercial property, you are guaranteeing the value destruction of your capital. This is especially true if you invest in cash and other ‘low risk’ assets because you want to avoid volatility. This is not a good strategy for long-term investing, productive assets are by their very nature volatile.
Ideally you should focus on the income from these assets. If the income they generate increases faster than the inflation rate, then the volatile nature of the capital invested is not as relevant. It is one of the reasons why Warren Buffett avoids IT companies; he cannot predict their income in the next ten years and therefore allocates his capital elsewhere.
If the markets do take a beating in the next year or two, it will probably be a good idea to increase allocation to shares beyond your normal targeted percentage but to always maintain some asset class diversification, just in case.

“Only those who will risk going too far can possibly find out how far one can go”.

T. S. Eliot