Picture: ISTOCK
Picture: ISTOCK

Taking the right investment risks is the key to creating wealth. To take the right risks you need to understand which risks will deliver the returns you need at a level of volatility that you can handle.

Then you need to find the fund manager that follows the investment philosophy that will deliver the returns you need over the period for which you will invest, with an acceptable level of ups and downs in your capital in between.

Rob Formby, chief operating officer-designate at Allan Gray, says a recent report reveals how US investors are playing it too safe to achieve their retirement savings goals. He thinks local investors are also too cautious as a number of Allan Gray investors attempt to keep the volatility of their investments low.

"As an investor, your risk tolerance is key to your financial freedom. While all investors want to avoid losing capital at all costs, playing it too safe, or being too conservative, can result in the loss of long-term returns."

To those shying away from risk, Formby says: "In the short run, your money is probably safe, but the returns that a money market fund offers may not keep up with inflation over time. In the long run, returns will not be enough to sustain you in retirement."

The converse also applies, he adds.

"If risk is underestimated, the ups and downs may be too much to bear for an investor and may force them to withdraw before an investment has had time to give them their required returns, or they may exit at the worst possible moment."

Ideally, you should determine the investment risk you require to deliver the returns you need - that is, the targeted return you need to make your investment grow to the required amount over your chosen time horizon. Think about the risk you take relative to the performance you need and then assess if you can tolerate that risk, as this influences the investment choices you make, Formby says.

He suggests you work out what investment drawdown or fall in your investment you can tolerate without being spooked, and match your tolerance with the kind of investment you need. Generally, the higher the equity exposure, the higher the fund's risk.

"A successful investment is when there is a match between the risk you expect and the actual risk of the fund," he says.

Paul Bosman, an equity analyst and portfolio manager at PSG, says your biggest risk is that of not achieving the returns you require. You should consider investment risks and the returns you earn over the same period. Don't focus on short-term drawdowns or volatility because this could lead you to switch funds at exactly the wrong time, missing the recovery in an undervalued fund, and investing in an overvalued fund just in time to experience a drawdown.

Bosman says missing your investment target even by a small amount can have big implications - a 2% underperformance of your investments can lead to 30% less retirement capital over a 35-year term. Investment mistakes are compounded over time, he explains. A loss of 25% in one year will require a gain of 33% to put you in the position you were in prior to the loss, and a 50% loss will require a 100% return to make up your loss.

He distinguishes between the risks of temporary and permanent investment mistakes. A temporary mistake is when the price of a share drops from fair or below fair value to a deeper discount to its fair price. Such mistakes tend to reverse when the markets calm down, Bosman says. In this case your portfolio may have a bad quarter or a bad year, as the shares you choose for your portfolio suffer only a temporary loss until the share price bounces back.

Your investments are unlikely to recover from permanent mistakes, however. These occur when you choose shares for a portfolio on the wrong valuation (price relative to earnings). For example, if you had bought Microsoft shares at the height of the dotcom bubble in 1999 at a p:e multiple of 70, you would have had to wait 16 years for the share price to recover, Bosman says.

Another mistake that can lead to permanent loss is choosing a share based on the company's current cash flow without considering the structural and competitive factors in the industry, he says. Kodak, for example, was a profitable company with the lion's share of the film and camera market in the US. Despite producing an instant-picture camera, it failed to keep up with technology changes and filed for bankruptcy in 2011 after its share price fell to a few cents.

Avoiding permanent losses also means avoiding companies with too much debt, making them incapable of weathering economic or industry-specific downturns, Bosman says. Finally, if you value a company based on financials that turn out not to be what you thought they were, such as Steinhoff's, you could be making a big mistake, he says. Cumulative permanent mistakes are detrimental to the long-term performance of your investment portfolio, but these can be minimised if your fund manager has a good investment process.

Arthur Karas, co-manager of the Old Mutual Edge 28 Fund at Old Mutual Investment Group, says you should not assume that any equity portfolio that deviates greatly from the index increases its underlying risk. By deviating from a specific index, a portfolio manager takes a more active position and increases its capacity to generate excess returns. There is also the risk of underperformance relative to that index.

But Karas says hugging an index too closely when the benchmark index is highly concentrated, as it is in South Africa, can result in concentration risk that some managers find unacceptable. The 10 largest shares in the FTSE/JSE Top 40 make up about 66% of the index's total market capitalisation, while Naspers makes up a little over 15% of total market cap of the JSE overall and more than 20% of the Top 40 and Swix indices.

He says while an index gives you an idea of how a fund manager has performed relative to their opportunity set, it is a poor indicator of how much risk has been taken to achieve that return. Active fund managers need to be confident enough to step away from the index when their research tells them to, and investors need to give managers room to underperform for periods in order to realise the value of their investment choices.