Managing Expectations

Mark Cliff of Alphen Asset Management says that investors should know the long- term facts about their investments and avoid short-term extrapolations to avoid disappointments.

Wow! Before we begin today, let’s take a quick moment to look back at the first weekend of World Cup 2010. The fact that South Africa has actually delivered the stadia and all the major promised infrastructure may by now have come as a surprise to the Afro-pessimists, but will have only served to reinforce the conviction of those whose blood runs green and gold that we are a nation of people who, when opportunity presents itself, rises to the occasion. We also saw some fantastic football over the weekend and even the most ignorant of watcher must have been impressed with Germany’s performance last night over the simply overwhelmed Australian Socceroos.

Not all went according to plan, however, with reports of some significant transport delays to and from games and, last night, an incident in Durban where police were called in to disperse “around 500” protesting World Cup workers from the Moses Mabhida Stadium. Reports via AP and Reuters state that the workers, who had been deployed as Stewards in the ground, were protesting that they had not been paid “what they had expected”. The workers were apparently paid R195 for their day’s work, whilst they had apparently expected somewhere between R425 and R1,500 (reports differ). Clearly, there was a chasm between what was expected, and what was delivered, and this has lead to a very unhappy outcome.

This brings us to today’s topic – keeping realistic expectations when it comes to investment returns.

It should be no secret to regular readers of the Alphen Angle that we are firm believers that an asset class is so defined because it has certain unique characteristics – particularly characteristics of return and the variability thereof. An asset class has been defined as “a group of securities that exhibit similar characteristics, behave similarly in the marketplace…” (Investopedia.com) or “a broadly defined group of securities that have similar risk and return characteristics” (FinancialLibrary.com).

Take, for example, one of the best-known and the most watched domestic asset class – South African equities. This asset class is made up of all the listed securities on the local bourse from time to time. The Johannesburg Stock Exchange was established in 1887 in Johannesburg and, since then, has provided a platform for the listing, buying and selling of securities in South Africa. Since then, there have been some rather detailed records kept of these transactions for each counter and various groups of stocks grouped together in various indices (like the Resources index which is an amalgamation of the price movements on the Resource stocks).

An analysis of this data will reveal certain characteristics of this asset class in general. Firstly, when compared to other domestic asset classes like cash and bonds, equities tend to produce the highest returns over the long-term. Secondly, the variability of equity returns from their average over almost all periods is very high – significantly higher than the variability of returns for cash and bonds.

We believe that investors who invest (all or part) in a particular asset class should take the time and effort to familiarise themselves with the characteristics of their investment – with particular reference to the time period over which they are either investing or over which they intend to evaluate their investment.

The graphic below shows the total returns of the ALSI over 50 years between 1959 and 2009 over various rolling periods.

The blue dots represent the best returns for each rolling period and the red dots the worst. The green dots represent the average returns for each rolling period.

Notable from this graph must be the extreme variability of the returns over the shorter periods. Over a rolling 12-month period for example, whilst the average total return on the ALSI was 21%, one could also have lost nearly half of one’s money or increased it by more than 120%!

Beware of Extrapolating Short-Term Data

Managing investment expectations is critical to avoid disappointment. Based on the graph above, any investor who expects not to lose any money investing in SA equities over any period of less than 60 months or longer, leaves themselves open to some significant disappointment. Similarly, the danger of extrapolating recent (short-term) returns into the future can also lead to significant disappointment.

Take, for example the 24-month period which ended at the end of May 2008. Over that period the total return of the ALSI was an annualized 25.4%. Over that period, cash returned an annualized 8.9% and bonds an annualized 2.4%. The 24-month period subsequent thereto saw a very different picture, with the ALSI’s -8.5% annualized return, relative to cash’s 9.0% and 12.1% for bonds.

Investors who based their expectations on an extrapolation of the returns of the equity portion of their portfolios leading up to April 2008 would have been very surprised and unhappy with the result over the corresponding 2 year period.

Your investment returns will be determined by your asset allocation and investment horizon. Ensuring that you know the possible outcomes of investing in a particular portfolio over your investment horizon will ensure that you don’t have any nasty surprises and unmet expectations.

The Alphen Angle is an electronic newsletter of PSG Alphen Asset Management. To read more about PSG Alphen please go to AlphenAM.co.za