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Volatility feels like risk. The daily noise, the red screens, the uncomfortable drawdowns – these are the stress points for investors. This is what might keep you out of the market altogether.

But what if the real risk was avoiding the markets over the long-term, rather than managing the bumps along the way?

In this episode, Satrix CIO Kingsley Williams joins The Finance Ghost to unpack one of the most powerful (and misunderstood) truths in investing: playing it safe may be the riskiest strategy of all. “Over-saving” and “under-investing” can severely damage a long-term wealth creation journey.

In this episode:

• Why volatility is uncomfortable, but not the risk you should fear most
• The concept of opportunity cost risk and how it destroys long-term returns
• How time in the market reduces the probability of capital loss
• Why equities remain the most reliable long-term hedge against inflation
• The critical difference between saving and investing (and why it matters)

This podcast was first published here

Transcript:

The Finance Ghost: Welcome to the Ghost Stories podcast, and I’m looking forward to speaking to Kingsley Williams today. He is the CIO at Satrix. He is certainly no stranger to the Ghost Mail audience. We’ve spoken to Kingsley many times before on Ghost Stories podcasts.

Today, we are going to talk about the risk of playing it safe. Isn’t that a fun topic?

And that’s because volatility is what we feel every day in the markets, and certainly, the first part of this year would definitely fall into that category of being volatile. The reality is that over the long term, it’s actually inflation that hurts us, not so much the volatility.

So, Kingsley, thank you for joining me to talk about what I think is quite a tough mindset shift for investors, actually, as they learn to deal with market volatility. I think you’re going to really give us some excellent context, on just how important this stuff is long term.

Kingsley Williams: Yeah, really great to be speaking to you again, Ghost. And it’s very, very important that we keep in mind what we’re ultimately investing for. Whether that be retirement, your kids’ university education, whatever that long-term goal might be.

Investing, in my mind, is inherently a long-term endeavour. As opposed to saving, which typically has a shorter-term horizon. Investing is also inherently a risky endeavour. The objective is to grow your capital in excess of inflation. If that isn’t your objective, all you’re doing is saving and trying to keep pace with inflation. In other words, having the same purchasing power tomorrow, next year, etcetera, as you would have today.

So I think it’s important to frame what we mean by investing and some of the assumptions that underpin that.

The Finance Ghost: Yeah, absolutely. One of the statements that you made to me in the prep for this podcast is that the greatest risk is not taking any risk. And that’s such a powerful statement that I think it really does deserve to be unpacked properly.

I’m keen for you to walk us through exactly what you mean by that. Especially for investors who do tend to be cautious and put their money in money market accounts, even when that investor is quite young, and maybe they actually have enough in the way of emergency savings. 

You’ve already alluded to the importance of saving versus investing. These are two different things, but I think there are a lot of people who over-save and under-invest (perhaps the best way I can describe it).

Kingsley Williams: One of the key concepts, the simple but most profound concept that I learned when I was doing my investment studies, is that of investment term.

This concept was clarified when I was actually doing some elective units at the University of Chicago Booth School of Business. Just as an aside, how do you know someone has an MBA? (laughs) They’re going to tell you, right? They’re going to tell you.

Just to be clear, I didn’t study full-time at that university or graduate there, but I did have the very fortunate opportunity to spend three months on an exchange programme through Wits Business School, which is where I did my MBA.

The University of Chicago Booth School of Business is the top finance school in the world. It was when I did it. I’m sure it’s still right up there. There are many Nobel laureates who have their professorship there, etc. Phenomenal opportunity for anyone wanting to get exposure to that side of the world. I digress a little bit.

But you touched on it at the beginning in terms of how we often look at volatility, or standard deviation, or variance as our primary measure of risk. And I think that’s because it’s a relatively easy-to-quantify and understand measure. It’s a measure of the bumpiness of the ride. 

But it doesn’t really tell you what investors probably care more about, and that’s ultimately the risk of loss. And we can talk more about that. There’s another key risk as well, which is the opportunity cost risk, which is not taking enough well-rewarded risk.

I’ll come back to those two key risks, which I think is what investors should probably think more about rather than volatility in and of itself.

So one of the things to recognise with investing is that it is very difficult to quantify what the actual return for a particular asset class may be over a given period. There’s a lot of estimation risk associated with that. Are equities going to go up 5%, 10%, 15%, 20%, 25% over the next 12 months, or even deliver a negative return? 

Yes to all of the above, and in no particular order, right? Any one of those outcomes could potentially happen because there are some known variables that could drive what that return outcome could be, but there are also a lot of unknown or unpredictable variables that also influence that final return.

And even with those known variables that are going to drive what an equity return is over a medium- to long-term period, there are a lot of unknown events that could affect those known variables.

It’s a lot of unknown unknowns, that can ultimately influence your long-term return!

So how on earth does one end up deciding what to invest in? Well, an interesting thing happens when you start expanding your time horizon, because you start getting a little bit more certainty around what is more likely to transpire than when you look over a relatively short period (even over 12 months).

One of the other things that we do when we do this exercise of looking at asset class returns is you could look at a long period, say like 10 years, but we don’t just pick one period, because in that one 10-year period there would have been a lot of macro and geopolitical factors at play that would have influenced the returns for that particular 10-year period.

So you want to look at lots of 10-year periods, all of the 10-year periods over a longer horizon, say over a 20-year period or 25-year period. Then you start getting an indication of what the average return is over all 10-year periods over that 25-year period.

And you could even argue that even that 25-year period is not really long enough, because even that 25-year period is going to be shaped by macroeconomic and geopolitical phenomena, that shape the returns of various asset classes over that timeframe.

The reality is, you start running into the accessibility of data and comparability of different asset classes. We’ve gone back about 25 years, but you could very much make the argument that that’s not even long enough. 

You start getting what becomes more typical for the different asset classes, even over that period. Because it’s corroborated by other research that other academics have done over the centuries even, which shows that basically equities are going to be your best performing asset class over the long term.

Let’s just delve in a little bit, into what we see over a shorter period, if you hold a particular asset class like local equities. So even over a 25-year period, while that’s relatively short, if you think about your total investment journey, it might only be half of the period of time that you’re saving for. Let’s say you have a 40-year period of time that you’re investing for.

Even though 25 years is relatively short, we have experienced some significant market events over that period. The dot-com crash, the global financial crisis, and obviously, more recently the COVID lockdown, how markets responded to that. 

There’ve been lots of other market regimes historically that wouldn’t be in that 25-year investment horizon, but there have been enough shocks to the system for us to stress test what is likely to happen should we have the next shock, whatever that might be.

What we see is that the longer you hold a particular asset class, for example, local equities, the risk of capital loss starts to decline. So, for example, if we look at all rolling three-year periods, local nominal bonds have not experienced any capital loss on a total return basis. In other words, that means by reinvesting your coupon income. 

While for local equities, you have on average lost between 5% to 10% of your capital, 5% of the time. So 95% of the time you’ve made a gain, but for 5% of the time, if you look at all rolling three-year periods, you run the risk of losing somewhere between 5% to 10% of your capital on a three-year holding period basis.

When you start looking at that data, you quickly recognise that you probably need to be holding local equities for at least a 10-year period to be assured, assuming history repeats itself, that you’re never going to lose capital. Because that’s certainly been the case if we look at the historical data. 

You haven’t lost any money if you’ve been holding local equities on a total return basis for a 10-year period. The risk of capital loss is zero. That’s certainly what has transpired historically over that 25-year period.

The question that we then need to answer is, why would I hold equities if bonds are that much safer? And I think this speaks very much to that second risk, that opportunity cost risk.

Let’s expand our horizon to, say, 10-year periods. And we look at all rolling 10-year periods. Local nominal bonds have delivered, on average, approximately a 9% return per annum; whereas local equities have delivered, on average, roughly a 12% return per annum. So, a whole 3% more than what nominal bonds have done.

So both have outperformed inflation, which is great, but there is a real opportunity cost there of not taking additional risk in equities if you have time on your side. So if you have a 10-year investment horizon, why would you care how bumpy the journey is? Because if you’re going to take a smoother, safer route, that’s ultimately going to cost you 3% per annum.

Your listeners should all be very aware of that eighth wonder of the world that’s often attributed to Einstein, of compounding. Basically, he said that those who understand compounding earn it, while those who don’t pay it. 

 It’s  in dispute whether he actually said it. I’m sure it’s accredited to him to add gravitas to the point. Whether he did or didn’t say it is up for debate, but the point is it’s no less powerful, right?

You want to take advantage of that 3% per annum compounding, because over a 10-year period that results in a massive difference in final value, which is ultimately what you’re solving for. So if you’re investing for the long term, you want to make sure you maximise the potential return. 

Because the bumpiness that you incur along the way is almost a moot point if you know that, with a high degree of probability, you’re going to lock in a materially higher return over that time horizon.

The Finance Ghost: That couple of hundred basis points excess is how careers are made and lost when it comes to active asset management, right? It makes a big difference.

The difference between the rockstar fund manager and just another normal, “average” fund manager can literally be 100 or 200 basis points over a long time. That makes someone a household name, quite literally. The compounding makes an enormous difference.

You’ve talked about the bumpy ride a few times. It’s like if you’re going on this dream trip, you’re going on this wonderful around-the-world story, a little bit of bumpiness on the plane doesn’t detract from how wonderful the end result is.

If you’re going on a short drive around the corner to the shops, you’re going to be irritated by something wrong with your car, and it’s very bumpy. But if you’re going on this big, long-term, exciting journey, then you’ll be willing to have some of the turbulence.

And that’s what investing is: the big around-the-world trip. That’s basically how important it is and how big the reward is if you get it right.

The other thing that you’ve raised there, which I think is important, is that yes, we have these market crashes, we have these issues that come through, but again, if you look over these 10-year periods, you let these cycles play out – ironically, if you’re early in your career, you actually want markets to crash so that you can buy more at relatively cheap prices.

Technically speaking, that’s what you want. What you don’t want is to be investing in really hot markets. That’s the big mistake that people make, right? They don’t necessarily up their investing when they can, when things are hard.

We’ve seen some of that now with some of the big tech names, etc, off 20%, 25%, 30% or more. That’s the time, actually. Not just blindly, you know, do the research etcetera, but it’s the old story – when everyone else is scared of the market, that’s the time to be thinking about upping your allocation.

Kingsley Williams: 100%. Investing is, as I mentioned at the beginning, risky, intrinsically. These market corrections and crises that happen from time to time (and even if we want to use the word bubbles, which happen from time to time), are features of investing. You were chatting to one of my colleagues this week as well, and talking about that very point.

The Finance Ghost: I was about to say Nico is going to shout at you for using the word bubble. [Laughs].

Kingsley Williams: Yeah, yeah. The exuberance that we see in certain sectors of the market at different times is actually what encourages the investment into those speculative new-generation technologies, for example. Which makes it attractive. That avails the capital to make investing in these new technologies worthwhile.

If there wasn’t that excitement, no one would invest in it because it wouldn’t have the potential upside returns that are promised. But yeah, does the market get greedy and get ahead of itself? Sure. Is there excess fear which results in a sharp correction? That also happens.

And these are well-known features, but what you have on your side is time. And as you give time to the equation, those bumps along the road actually become distant memories. And yes, as painful as they are when you experience them in the moment, it’s amazing how quickly we forget. 

And as the market recovers, it reaches new highs, because that’s what it’s meant to do. It’s not a bug when you have corrections or bubbles; they’re more of a feature.

The Finance Ghost: Yeah, absolutely. And the other thing that’s a feature is inflation, right?

And we’re seeing it come through now from listed companies, seeing it more and more in the SENS announcements that I read every day. Inflation is here. This oil price spike is going to drive inflation throughout the system. And obviously inflation, like any other macroeconomic concept, has cycles. So there are times of higher inflation, and there are times of lower inflation.

And so you’ve got to then distinguish between, well, what am I investing in, very long term, then maybe you don’t care too much about where we are in an inflation cycle – those who have more of a medium-term view will need to think carefully about that.

What would be, if I can call it the “wrong” exposure to have too much of in an environment where you’ve got higher inflation, you’ve maybe got interest rates that are going to be higher for longer as well? What would be the classic mistakes that people would be making in that environment?

Kingsley Williams: Markets will adjust to the inflation level at any given point in time, whether it’s low, medium, or high. But what I would say is one of the biggest risks for safer investments, particularly bonds, is actually inflation, but specifically inflation surprises. So it’s the change in inflation. 

Because the bonds will be priced on an assumption of what inflation is likely to be over whatever investment horizon you’re looking at, whatever the duration of those bonds are that you’re holding. But if the inflation dynamics change and those assumptions are now no longer valid, in other words, you face an inflation surprise, that’s where bonds are super sensitive.

This is also where you can get quite hurt by playing it safe, in an asset class that is supposedly safe, like bonds. If there’s a subsequent shock and surprise to that, that’s where you can get really hurt because those bonds are going to recalibrate.

There are other factors that affect bonds, like default risk and credit rating, ability to meet future payments, etc. But inflation’s the big one, particularly for government debt, which is less exposed to that default risk.

But to answer your question as well, equities are a great long-term hedge for inflation. If you think about it, companies will ultimately pass on inflationary increases to their customers. So as long as the business remains viable, and it can compete within its industry and its sector, they’re going to be hedging against inflation by passing on those increases to counteract the effect of inflation on their costs, revenue, and profitability.

Higher-for-longer inflation is therefore not a problem per se. Obviously, it does generally correspond with a higher risk-free capital rate, which affects equity valuations. But I think the bigger risk is an inflation surprise, as that upsets the real return expectations.

Businesses can adjust if they have a common understanding of what the expectations for inflation are likely to be. Because that gets baked into the system and they price accordingly.

Within equities, at Satrix we tend not to make calls on different sectors, as there are a lot more variables within a particular sector to now consider one sector versus another, and therefore more known and unknown surprises to those expectations.

So we would rather look at broad asset classes in terms of where we want to position our portfolios, particularly our balanced funds.

But if we come back to real returns, so in other words returns in excess of inflation, this is ultimately why we invest, right? That’s what we’re trying to solve for. We want to deliver a return in excess of inflation. It’s important for investors not to lose sight of that when looking at their returns in the longer term.

It’s the return in excess of inflation, and giving appropriate time for that investment to appreciate in excess of inflation, which is ultimately what investors should be solving for, and why they invest in the first place. Not to protect capital or merely keep pace with inflation.

And the key ingredient that unlocks that is the appropriate amount of time in relation to the asset class that you’re investing in. Equities are a great long-term hedge against inflationary effects for the reasons that I mentioned earlier. But beware, while bonds appear safe, inflation is the big Achilles’ heel that can trip them up.

So you can play it safe, but actually, you can have a big risk if there is an inflation shock to the system, like we’re experiencing at the moment.

The Finance Ghost: Kingsley, you’ve raised a lot of important risks there around bond investing. And I always remind people that it’s called fixed income, not fixed returns. Two very, very different things.

You’re not going to get a fixed return from a bond because the traded value can and will move around based on the income it’s paying in relation to what’s going on from a macroeconomic perspective. So, always something important to keep in mind.

We’ve talked a lot about how time in the market is really important. The old story: you get a good return from equities by hanging around for a long time. But if you’re not diversified, then that may not hold true.

So it is very important to make sure that you are playing the game from a diversification perspective. Because if you’re going to go and own two or three or four different stocks, or you go and own 20 stocks with exactly the same underlying fundamentals, then that’s not diversification, and there is no guarantee whatsoever that you will do well or that you will make excess returns or anything of the sort.

And obviously, ETFs like the ones offered by Satrix do make that a lot easier. But what makes it a lot harder is that global indices are not as diversified as we might like. If you are buying a market cap-weighted index, you’re not necessarily getting that diversification because of the way the world has gone, where so much value is now concentrated in a relatively small pool of companies and sectors like tech, for example.

So how do investors actually go about addressing that risk, and making sure that they’re not falling foul of the need to diversify?

Kingsley Williams: Completely agree with your points there, and the importance of diversification. Very important to take well-rewarded equity risk over an appropriate time horizon. And as you’ve already mentioned, it must be well diversified.

And the reason why is that you want to minimise what we call idiosyncratic or company-specific risk and avoid losing all of your capital or having it written down significantly, which can easily happen with a particular company. 

It can face some scandal or some controversy, or some unknown risk that literally can result in that company no longer existing, and your investment becoming completely worthless.

So that’s why you want to diversify. It doesn’t diversify all your risk away, but it removes, close to zero, your idiosyncratic or company-specific risk if you’re well diversified.

However, diversification is not as straightforward a thing, because lots of companies in and of themselves may end up being less diversified in an extreme case. For example, you could hold lots of companies in a portfolio, but they might all operate in a single sector or geography or have a big concentration around that.

Whereas it’s possible to have a portfolio with a few companies in it that are themselves very well diversified. Think about different business lines, geographical exposures in which they operate, or different types of assets and business models that they generate revenue from. So that helps to diversify your mix. That’s why I say it’s not so straightforward to think about.

If you think about what you’re investing in when holding a broad basket of companies, you’re actually investing in the future revenue streams of all those companies, as well as any innovation they devise to overcome the challenges a particular business or industry is facing.

And let’s make no mistake, there is a lot of pressure to find those solutions, as remuneration incentives for employees, and particularly executives, are a big motivator. Or, not receiving those remuneration incentives is a big motivator. 

Or in a worst-case scenario, actually losing your very livelihood in your job because the business has to restructure or downsize. Jobs may be on the line if they haven’t delivered.

Coming to your point around market cap weighting, that’s a very interesting one. Ultimately, if we think about what a market cap-weighted index represents, it’s the sum total of what all investors in the market are holding in aggregate.

For every investor that’s overweight a particular company, there must be another investor or investors who are underweight that company, with the neutral position being the market cap-weighted index.

So when you think of a market cap-weighted index, it is the sum total of what all investors collectively hold. You could have extremely concentrated portfolios on the one end of that distribution, and then extremely diversified, or where you’ve solved for some other measure of concentration on the other end.

The market cap portfolio is the ultimate representation of what all investors hold in aggregate.

So talking about equal weighting, for example, as a way to diversify, is quite an extreme contrarian position to take. Because it says: regardless of where the collective wisdom of all investors is centred, which is the market cap-weighted index or portfolio, it ignores that and down-weights the largest companies to 1/N. 

If there are N companies in the universe (take an MSCI World Index, there’s 1,300 of them, give or take), you’re only going to hold 1/1,300th weight of each company in your portfolio. And similarly, you’re going to upweight all the smaller companies that might have a very minuscule weight, also 1/1,300th.

So you’re going to be big upweight on the small companies and massive downweight on the largest companies. It’s quite an aggressive way to tackle the diversification problem. And you could end up with a portfolio that has significant tilts from a geographical and a sector perspective that looks very different to the market cap-weighted portfolio, which as I mentioned earlier is the aggregate of what all investors are holding. That is ultimately the representation of what the universe looks like at the midpoint.

Equal weighting, for example, as a solution to that diversification problem, also has some pretty practical implications as well, such as liquidity. You’re now having to significantly upweight smaller companies, as well as trading costs, because now every time you rebalance that portfolio, you’re going to have to trade against market movements to bring everything back into a 1/N weight to keep that portfolio equally weighted.

To conclude on this point, if you’re trying to solve for risk, it’s better to be explicit about which risk you’re trying to solve for. For example, sector exposure or geographical exposure, or largest company weight or overall volatility. Those would be “measures of risk”.

And solve for those explicitly, because when you solve for that, there is always going to be some unintended consequence. Solve one problem, but you might introduce another into the portfolio. Diversification is an easy thing to talk about, not necessarily the most obvious thing to solve for. You might be solving that risk, but introducing many other unintended risks in the process.

The Finance Ghost: Fantastic. Lots of great stuff for people to think about there. All those smart choices etcetera.

But the one thing we haven’t talked about is: there is a way to do it in South Africa that gives you an additional benefit, which really then tilts it in favour of equities (in my opinion), and that is of course the tax-free savings account, which has become a more and more popular tool for South Africans.

I personally use it with a nice heavy tilt towards property ETFs because then I get a nice tax-free dividend, and I get the capital gain that comes from having these portfolios in South Africa, which works really well.

What do you do with yours, Kingsley? Because I don’t doubt that you are a tax-free savings man who maximises his amount every year. Where does it go? What sort of equities do you buy? Or do you just give it a nice spread?

Kingsley Williams: Great points there. There are only two certainties in life, right? Death and taxes. But in this case, you can avoid one of them.

So you definitely want to be taking advantage of any opportunities to reduce your overall tax effect on your savings. If we’re talking about investing, there are two big factors that erode your outcome from an investment return perspective. 

Tax is a huge one. So if you can ensure that your investments are not being subjected to tax by investing in tax-efficient vehicles like tax-free savings or tax-free investments, and similarly RAs as well, which also have tax benefits, retirement annuities, those are no-brainers to take advantage of.

The other big erosion of return is costs, and obviously, Satrix has very much been at the forefront of reducing that for investors.

When looking at what to invest in, particularly within a tax-free investment wrapper, let’s go back to the beginning. To quote The Sound of Music, that’s always a good place to start. 

What you want to be thinking about is: which index or asset class offers the best long-term return? First and foremost, that’s what you want to be solving for. And then do that in a tax-efficient way, because you’re going to be subjected to tax on all types of investments.

So while REITs, for example, like listed property, which you mentioned, would have a big tax advantage from a dividend or an income perspective because they are high-yielding type investments, you ultimately want to be solving for your total return. And equities also have tax implications on a dividend perspective and on a capital basis.

So, within a tax-free savings vehicle, you avoid the implications of capital gains and dividends withholding tax, which also cause a drag on your returns. So I think you want to go back to the beginning and say, I’m ultimately trying to solve for maximising my return over a particular term, hopefully 10 years plus. 

Therefore, how do I get the best investment over that horizon and invest in that? That’s the way I would think about tax-free investments, making sure I’m exposed to asset classes that are going to give me the best long-term return.

If you solve just for the tax implications on a yield basis, for example, you may end up solving for the wrong thing, because you’re now getting a big tax kick on bonds, for example, which is subject to income tax, which you would not be paying in a tax-free investment wrapper. But you’re ultimately still in a 3% less return over a long-term period than what equities would give you.

You’re solving for tax efficiency without solving for the long-term investment outcome.

The Finance Ghost: Thank you, Kingsley. Lots of great insights there. Always appreciate your time.

To those who want to engage with you, you’ll find Kingsley on LinkedIn; chat to him there. Go back and look at some of the other podcasts that I’ve done with Kingsley as well. There have been a number of them, and they are all very interesting.

Kingsley, thank you.

Kingsley Williams: Thank you very much, Ghost. Always great chatting with you.

Disclaimer

Satrix Managers (RF) (Pty) Ltd is a registered and approved Manager in Collective Investment Schemes in Securities. Collective investment schemes are generally medium- to long-term investments. With Unit Trusts, Exchange Traded Funds (ETFs) and Actively Managed ETFs (AMETFs), the investor essentially owns a “proportionate share” (in proportion to the participatory interest held in the fund) of the underlying investments held by the fund. With Unit Trusts, the investor holds participatory units issued by the fund while in the case of ETFs and AMETFs, the participatory interest, while issued by the fund, comprises a listed security traded on the stock exchange. ETFs and AMETFs are registered as a Collective Investment and can be traded by any stockbroker on the stock exchange, LISP platforms and / or via online trading platforms. ETFs and AMETFs may incur additional costs due to being listed on the JSE. Past performance is not necessarily a guide to future performance, and the value of investments / units may go up or down. A schedule of fees and charges, and maximum commissions is available on the Minimum Disclosure Document or upon request from the Manager. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Should the respective portfolio engage in scrip lending, the utility percentage and related counterparties can be viewed on the ETF and AMETF Minimum Disclosure Document. AMETFs are ETFs are actively traded by a Portfolio Manager to adjust the AMETF holdings and asset allocation with the aim to outperform the benchmark. AMETFs differ from ETFs which only track indices. The Manager does not provide any guarantee, either with respect to the capital or the return of a portfolio. The index, the applicable tracking error and the portfolio performance relative to the index can be viewed on the ETF and AMETF Minimum Disclosure Document and/or on https://satrix.co.za/products.