Don’t be tempted by cash returns
How can investors overcome their negative biases and avoid selling their equity holdings in market downturns?
Among many other behavioural biases, humans suffer from recency bias and loss aversion. Both of these appear to have influenced South African investors in recent times, as poor equity returns over the past three years have sparked a move out of equities and into better-performing investments like cash.
Recency bias is the tendency to overweight recent experiences when forming a view of the future. So, if the equity market has lost 15% in recent weeks, you would be inclined to believe that equities tend to lose value more often than not, and therefore you would be more likely to be wary of equity investments.
Loss-aversion theory, meanwhile, holds that people’s pain from a particular loss weighs a lot more in their mind than the joy they would experience from making a similar gain. This bias against losses makes it harder for investors to weather the downturns in the more volatile equity market, and underpins a natural risk intolerance among most people. And the human urge to act increases significantly after a period of poor performance – in this case making investors want to switch from underperforming equity assets into better-performing cash assets to avoid losses, expecting the short-term historical returns to continue into the future.
Cash outperformance is cyclical
Until May 31 2017, the average South African general equity fund returned only 0.4% per year over one year and 3.6% per year over three years (both after fees), underperforming the average money-market fund return of 7.8% per year and 7% per year, respectively (after fees).
Yet that should be recognised for what it is: a short-term cycle. Over the past 40 years, South African equities have returned 8.2% per year on a real (after-inflation) basis, much higher than the 2.8% per year real return delivered by South African bonds and the 1.8% per year real return from cash. This makes them an invaluable part of an inflation-beating portfolio over time and gives investors a compelling reason to hold them through the downturns.
The graph below, dating back to 1966, highlights how there have been many similar periods in South Africa during which equities have underperformed cash, with returns broadly following the interest rate cycle – the latter shown by the black line. (Red indicates periods where equities have outperformed cash over the preceding 12 months; gold depicts underperformance).
It shows how, although local equity returns do soundly beat cash over time, they underperform during relatively short periods, especially when interest rates rise, only to beat cash again as interest rates are falling. This underperformance is particularly evident when interest rates peak, as is the case currently. Based on this historic cyclical pattern, equity returns could begin to outperform cash again as our interest rates fall. And it is worth noting that the South African Reserve Bank has indicated no further interest rate hikes are likely in the current cycle.
Timing cycles of asset under-/outperformance
A closer examination of the asset return cycle in 2003-04 shows that the average South African general equity fund, with a 12-month return to April 20 2003 of -15.7%, badly underperformed the average money-market fund’s 12.2% return (both after fees) over the same period.
However, 12 months later this was reversed: the average South African general equity fund returned 50.3% for the 12 months to April 30 2004, while money-market funds returned 10.5% on average. Had investors decided to switch their equity exposure to cash following the poor 2003 equity returns, they would have missed out on its exceptional returns the subsequent year.
There are many other examples of these short-term turnarounds in asset returns (1998-99, 2008-09 etc), partly due to the quick impact of moves in short-term (three-month) interest rates. It is impossible for investors to foresee such turns in the cycle with 100% accuracy and take full advantage of them. This means they miss out on periods of improving equity-market returns. Therefore, investors’ best option for building wealth is to hold their equity exposure through interest rate and asset return cycles over the longer term.
Overcoming the urge to switch to cash
So how can investors overcome their negative biases that push them to sell their equity holdings in market downturns, only to miss out on the upturns and destroy the value of their own portfolios?
It is important that their expectations are correctly managed upfront, so that they know what’s coming before they invest in equities. A look at the FTSE/JSE all-share index shows the equity market has experienced average calendar-year declines of 16.1% since 1980 – a substantial drop. Despite this volatility, however, equities recorded positive annual total returns in 30 of the 37 years (1980-2016), giving investors a bumpy but rewarding ride over time. For example, there are years such as 2004 that saw the all-share index drop by 12% at one point (from peak to trough), but it still produced a total return of 25% in that year.
Attend the summit
Another tool for managing volatility is having a long time horizon. Investors should only put large portions of their investments into equities if they are committed to an investment horizon of at least five years. Time helps smooth out the equity market’s highs and lows.
Diversification, even within equities, is another powerful tool for managing volatility. It also reduces the range (and extremes) of investment outcomes over any period.
A financial adviser can help investors develop an appropriate long-term financial plan and stick with it, so that they have the correct mix of growth assets to meet their long-term investment goals.
Prudential is presenting at the Allan Gray investment Summit on August 31 at the Sandton Convention Centre, Johannesburg. This new one-day event aims to help investors protect and grow their wealth. For more information and to book tickets, visit www.investmentsummit.co.za.
Pieter Hugo is MD of Prudential Unit Trusts.
This article was paid for by Allan Gray.