“To generate the same level of return, you have to stomach a lot more risk,” says Allan Gray portfolio manager Simon Raubenheimer.
However, asset managers can never know for sure what the risk in any asset is, or the real return. Even cash in the bank is affected by interest rates and inflation, which can’t be predicted with any certainty.
“As you take on more risk, you don’t necessarily generate higher returns,” Raubenheimer adds. At any level of risk, the potential exists for a range of outcomes. With lower risk investments, that range is smaller and more predictable. “As you take more risk, you should do better on average. But you could also do a lot worse or a lot better. You never quite know beforehand.”
This is a critical consideration currently, as many investors have moved into riskier assets.
The sustained bull run in equities over the last 15 or 16 years has certainly blinded many people to the fact that markets always work in cycles. They don’t keep going up forever. Given current levels, taking on more risk is perhaps not the best idea.
Investors must remember that what we’ve seen in domestic equities recently isn’t the norm. When making equity investments, be very cognisant of the valuations you are buying at.
Most of the time a buy and hold strategy is the right approach, but avoiding the peaks (when the market’s really expensive) is more important.
Are we there?
“Valuation is what drives future returns, and we are certainly not at a low point,” Raubenheimer argues. “In 1983 you could buy the whole stock market at five times earnings. Today, we are sitting at a price-to-earnings (PE) multiple of 17.7 times.”
The long term average PE multiple on the JSE is 11.9 times, so it’s currently above average – meaning future returns are likely to be lower.
“We don’t know the future, but what we do know is that markets are cyclical and while financial history doesn’t repeat itself exactly, it does rhyme,” Raubenheimer says. “We can look back over the last 55 years and ask what would have happened to you as an investor if you bought shares at a market PE of 17.7 times.”
In real terms, investors would on average lose money over the first 12 months of such an investment.The average break-even point is around 42 months down the line.
Raubenheimer argues: “…Historically, a market at a PE of 17.7 times is a bad time to be buying shares. Because valuations are high, risks are high, since the higher the PE the more you depend on future earnings to justify today’s valuation, and we know that the future is uncertain.”
Just taking on risk is not a guarantee of returns. You have to be cognisant of your entry point.
If you’re already in shares and have a long investment horizon, you have less to worry about. You can sit out a period of under-performance. But if you have only a few years to play with, perhaps you should think about taking some of the money you’ve made in equities off the table. And maybe you shouldn’t be thinking of buying any more.