However, average returns (8,5%) began to moderate in 2015, dropping still further in 2016 (3,5%), the lowest since the Global Financial crises in 2008. Partly, this was due to the strong recovery in the rand, which more than offset the positive dollar returns earned internationally.
Nonetheless, having become accustomed to above-average returns over the prior seven years, some investors expressed surprise and concern about these more modest results, and questioned the suitability of a high equity strategy “in the current environment”.
Fig 1: Annual returns of the 10X High Equity portfolio (2009 – 2016)
Modest, or negative return years are an inevitable part of investing. Not even hedge fund managers, who stake their reputations on delivering positive returns, are immune. But this should not concern you.
Long-term investing is not about managing returns, it is about managing your market risk.
It is about achieving an optimal performance that meets your stated (and realistic) investment objectives. It is about staying committed to your strategy, without being distracted by market cycles. It is about ignoring volatility, the market noise and the fear mongers. This drama feeds the world of speculators; as Nobel laureate Paul Samuelson famously remarked, investing should be as exciting as watching paint dry.
Your level of market risk (equity exposure) is something you set up front, based on your time horizon. You do this with the aim of maximising your average return over the whole period, not for the next month or next year. For long-term investors (investing for periods longer than five years), this will require a high allocation to a well-diversified equity portfolio. Historically, a high equity portfolio has generated a higher return over periods longer than five years than a low equity portfolio, despite greater return fluctuations.
You should expect volatility with such a portfolio. The graph below approximates the annual pro forma returns of the 10X High Equity portfolio since 1900, based on its current asset mix. Quite aptly, the graph looks like a sound wave because the annual market moves include a lot of noise. These short-term return variations are random, impossible to predict and cannot be managed.
Yet too many people let this influence their investment decisions, and how they should invest their long-term savings. It leads to goal-defeating habits such as chasing past performance, making tactical (or panicked) changes to the asset mix and alternating fund managers. The most sure-fire way to fail at long-term investing is to regularly deviate from the initial plan.
Fig 2: Annual return of 10X High Equity portfolio 1900 – 2016 (pro forma)
Benjamin Graham famously noted that "in the short run, the market is a voting machine but in the long run it is a weighing machine". Nobody knows which way the vote will go short term. Over periods of 5 years or longer, market returns (net of inflation) become more predictable but they still fluctuate as the market moves through broad cycles.
For example, as you can see in the graph below, the average return from the 10X High Equity Portfolio in the 7 years ended 2016 was around CPI +7.7% before fees. This is above the long-term average of 6.5%. But you should also expect periods of below average returns. In rare instances, these deviations from the long-term average can run for a decade of longer. You manage this risk by owing a well-diversified, low cost portfolio that will earn you competitive returns through-out.
Fig 3: 7-year compound annualised return of 10X High Equity portfolio 1919-2016 (pro forma)
The fact is there is little chance then that you will fare poorly over the long term. What the market machine “weighs” long-term is intrinsic worth, the discounted value of its future cash flows. The expected cash flow, or the discount rate applied, do not change dramatically one year to the next; it is only investor sentiment that constantly shifts.
Over time this intrinsic value shines through, as is evident in the long-term graph of the pro forma 10X High Equity portfolio (shown in Fig 4 below, on a log scale). R100 invested in 1900 would have grown to roughly R151,000 in real (after-inflation) terms, a growth rate of about 6,5% pa. Here you will notice that the randomness – the annual gyrations – have disappeared. The (very) large market corrections can still be seen, albeit as minor blips, and the broad market cycles reflect as changes in the gradient:
Fig 4: 7-year compound annualised return of 10X High Equity portfolio 1919 -2016 (pro forma)
Despite these short term fluctuations, the overall trend however is onward and upward. As a long-term investor, you only capture this in full if you stay the course.
