Issue: Mar/May 2011
Back to Basics 3

WHERE TO PUT YOUR EGGS

Diversification is the name of the game. Eleanor Fraser, an independent trustee educator specialising in governance and investments for retirement fund trustees, shows why.

Equities and bonds are invariably held in the portfolios of retirement funds. The choice for trustees is how to spread their fund’s investments across them or, put another way, how to combine investments most effectively in these two asset classes.

Consider an average retirement fund member. Between the member’s and employer’s contributions to the fund, let’s assume total contributions of 15% of the member’s pensionable salary. Of that, say 3% is used to provide risk benefits (life and possibly disability insurance) and a further 1% to pay for administration costs. This leaves 11% of the retirement-funding part of the member’s annual salary being saved to provide him or her with a post-retirement income.

How pleased would you be if, on retirement, you found that this 11% saved over your 40-year working life had not grown sufficiently to provide more than 11% of your pre-retirement salary as your pension? Probably not pleased at all. No, most retirement fund members expect the amount invested to grow substantially in order to provide adequately for their retirement. So simply keeping pace with inflation is not going to be enough.

Risk and return

Why do investors (whether they are members of retirement funds or simply holders of deposits in banks) expect a return before being willing to part with their money? Four main reasons:

  1. To maintain purchasing power: in other words, to protect the money saved against the ravages of inflation and enable the investor at least to have sufficient money to purchase the same items at the end of the investment period (but we already know that this is not going to be enough);
  2. As compensation for delaying consumption: instead of investing the money, the investor could have spent (or consumed) it and needs to be compensated for delaying this spending;
  3. As compensation for the opportunity cost of not having invested the money in a different investment opportunity and earned the return that investment offered; and
  4. As compensation for the risk taken by making the investment: the risk that the return expected might not be earned, or worse, that the return may be negative and money actually lost.

The risks related to an investment are inextricably linked to the return that the investor hopes to earn and that the investee (the party receiving the investment and supplying the return) offers the hope of delivering. This is one of the most fundamental challenges of investment.

On the one hand, investors (retirement fund members, for example) want to maximise the returns earned on their investments. However, in order to have the hope of earning higher returns, more investment risk must be taken. And that investment risk is exactly what the investor wants to avoid or minimise.

This creates a dilemma for the investor. His primary objective is to maximise return while minimising risk, but maximising return actually requires maximising risk.

Consider the chart in Figure 1 below. On the horizontal axis (the x-axis) the riskiness of each investment is plotted. This is measured by the standard deviation. On the vertical axis (y-axis) the actual return earned is plotted.


Figure 1: Risk return space - nowhere to go

Now, from an investor’s point of view, where do you want the performance of your investments to plot on this chart?

  • Top right? This implies high return (which is good) but also high risk (which is bad), so you probably don’t want to be here.
  • Bottom right? This implies low return (which is bad) but also high risk (which is also bad), so you definitely do not want to be here.
  • Bottom left? This implies low risk (which is good) but also low return (which is bad), so you probably don’t want to be here either.
  • Top left? Now this is more like it: high return (good) and low risk (also good)

But, when the actual returns to investments in listed equities (using the JSE/FTSE All-Share Index), bonds (using the All-Bond Index) and money market or cash (using the STEFI) are plotted, none of them are close to achieving what the investor needs in order to satisfy their investment objectives of maximising the return and minimising the risk, as you can see from Chart 1.

So what now?


Chart 1: Risk & return to different asset classes 1099 - 2009

Diversification -- in other words, not putting all of your eggs in one basket but instead spreading your eggs out across many different baskets -- is the primary means to achieving the best possible returns while at the same time minimising the investment risks.

This is illustrated in Chart 2 by the diamond-shaped marker. It shows the performance of a portfolio containing 65% listed SA equities, 25% SA bonds and the remaining 10% in cash or money market instruments. Notice how it has slightly more risk than cash and bonds, while delivering higher returns. And it offers a lower return than listed equities, while exposing the investor to lower risk.

So, some return has been sacrificed in order to reduce the amount of risk exposure. This is diversification, one of the fundamental concepts in building an investment strategy.

Diversification is more about risk management than return maximisation.