As the supporters of behavioural finance would say, investor behaviour affects market movement in the short term. If it didn’t, markets would most certainly go up in a straight line. Now that investor behaviour has probably had its worst effect on markets since the Great Depression, I think it is time to reflect on what principles apply to market movements over the longer term. To make sense out of all the chaos we should perhaps start thinking about principles that apply during 'normal circumstances'. Underlying all investment decisions is the trade-off between expected return and risk. Investors should consider both when compiling a portfolio of investments to suit their specific needs and expectations. The relationship between risk and return is a critical consideration throughout the investment process.

Investing is not gambling

Many people see investment as a gamble, but there is a fundamental difference between investing and gambling. To gamble is 'to bet or wager on an uncertain outcome'. If you compare this definition to that of speculation you will see that the central difference is the lack of 'commensurate gain'. Economically speaking, to gamble is the assumption of risk for no purpose but enjoyment of risk itself whereas speculation is undertaken in spite of the risk involved because one perceives a favourable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium to compensate risk-averse investors for the risks they bear. Hence, 'risk aversion and speculation are not inconsistent'.

Investors are faced with two primary dilemmas in saving for retirement or other financial goals. Firstly, excessive risk can be taken considering the investor’s risk profile and the investor stands the chance of losing capital. Secondly, the investor takes too little risk which could lead to inadequate growth to meet investment goals. Probably the most serious consequence of not meeting investment goals is that the investor is forced to lower his or her living standard as a result of inadequate savings after retirement. It is therefore critical that an investor takes appropriate levels of risk with capital to meet investment goals.

To illustrate the problem more clearly, consider the following two narratives: Mr X is 61 years old and has four years left before retiring. He calculated that he had a shortfall on his retirement savings and decides to invest in a more risky portfolio to try and make up for the shortfall. As previously explained, higher levels of return are associated with increased risk. Unfortunately for Mr X, his portfolio value fluctuates widely and he loses considerable capital value over the next four years. At retirement Mr X is in an even worse situation than before and he has to lower his living standard even more than he would have had to if he had invested in an appropriate portfolio. Mr X took on more risk than he could afford.

Not taking on enough risk is extremely risky

In another case; Ms Y is 35 years old and has 30 years left before she retires. She has never married and considers herself a conservative investor. She has heard many horror stories about investors who lost their life savings by investing in the stock market. Most of these stories she read about in newspapers that tend to sensationalise people’s losses. Ms Y made a decision to invest in cash investments only such as the money market, to ensure she does not lose any of her hard earned capital. Ms Y diligently saves a portion of her salary until retirement. She also has a pension fund with the company she works for, but here she also decided to always go for the lowest risk investment option. A few years before retiring, she comes to the shocking realisation that although she had saved her entire working career, her savings hardly kept up with inflation. She would not be able to maintain her current living standard and should have taken more risk to achieve higher inflation-beating return. Ms Y took on less risk than she could afford. Taking too little risk can have far-reaching consequences. No-one wants to run out of money and have to rely on others to fund living expenses.

Therefore it makes obvious sense that investors should invest in a portfolio that matches their risk profile as closely as possible. As wealth managers and financial planners we play a critical role in assisting our clients to properly define their true risk profile. Investors should be encouraged to play open cards with us. The more information they give us, the better the advice. The way people are investing has made a paradigm shift. One of the effects of the global financial crisis is that people are going back to basics in the way they invest money. Complex derivative structures are out of fashion. People want simplicity and transparency. One way of simplifying investment is to shed the layers to get to the core of the underlying investment. There seems to be a trend towards investment in direct cash, bonds, property and equities. Let’s investigate the investment in equities. Holding a portfolio of shares is certainly more transparent than an investment in unit trusts. The investor knows exactly what shares he/she holds, what income is earned and what expenses are levied.

The global financial crisis is giving investors a once-in-a-lifetime opportunity to invest

A segregated share portfolio also affords the investor some flexibility. For instance, I have a client who feels strongly about not investing in tobacco shares and another Muslim client who feels strongly about investing in Sharia-compliant shares. With a bespoke portfolio we can facilitate these very valid requests. Keep in mind that for smaller amounts unit trusts are a more appropriate investment because of the more favourable Total Expense Ratio. The global financial crisis is giving investors a once-in-a-lifetime opportunity to invest. The last time markets were this cheap was in the 1930s during the Great Depression. I believe the global economy and markets will recover.

If they don’t, will all of it matter anyway?

Jurie van der Merwe is a senior wealth manager with BJM Private Client Services

Published courtesy of Blue Chip magazine

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