I am in the last throes of finishing Crime and Punishment. I must admit that my innate obsession with completing things had a lot more to do with getting this far with the book than it being a riveting read. It is just too long.
However, something one of the characters in the book said stuck in my mind and rings true when it comes to investment thinking: "It takes a lot more than intelligence to act sensibly."
The concept of portfolio diversification, one of the cornerstones of building a portfolio that will serve you well in the long term without too many frequent modifications, is based on the long-term relationships between different types of investments.
For example, equities perform differently from cash over time, retail shares do not perform in line with mining shares, fixed interest performs differently from gold shares, offshore investments from the local market, and so forth.
The theory is that, based on your investment needs and risk tolerance, you should be able to build a portfolio that will weather short- and medium-term volatility because it consists of different types of investments.
The problem with statistical measures, such as correlation, is that, while useful in the long run, they are not all that stable or indicative in the short term.
Correlation is a measure used to demonstrate a possible relationship between two factors; for example, how an increase in the interest rate can affect the spending of consumers as measured by retail sales.
Let's test some well-known investor responses that are founded on the analysis of long-term trends, when set against the behaviour of the market over the past two months. I will focus on two aspects, namely beta investing and gold shares as a hedge against disaster, or put differently, a safe haven in inflationary times.
After all, inflationary fears were a major factor behind recent market declines.
The beta of a share captures the sensitivity of that stock's movement to that of the market. It also captures the magnitude of that movement. The neutral position is a rating of one, so 1.5 would be on the high side, 0.5 would be low.
If the stock's beta is 1.5 and the market rises by 10 percent, then we would expect the stock to increase 15 percent. Alternatively, if the market were to fall 10 percent then we would expect the stock to fall 15 percent.
If the beta is 0.5 and the market falls 10 percent, then we would expect the stock to fall five percent, as it is half as sensitive to market movements. High beta shares also tend to be more volatile.
How do investors use the concept of beta in investing?
One way is to buy high beta (aggressive) shares if you think it is a bull market and low beta (defensive) shares if you are concerned about a bear market or a correction.
Another option is to buy an index fund to ensure that you get full market exposure (and a beta of one, the same as the market) and to use alternative investments to get your alpha (such as hedge funds or specialist equity managers).
Alpha is the value added or detracted by an active manager.
Low beta sectors in the South African market include food, healthcare, pharmaceuticals, banks, property and smaller companies in general.
High beta shares are usually found in the resource and IT sectors. (There are, of course, exceptions within these sectors).
During the past two months, however, the best performing shares have been the resource shares. Anglo, Amplats, Billiton and Sasol fared better than the market in the past two months. They happen to be so-called high beta shares, so what was the catch? Why did the practice of low beta investing not work in turbulent times? Why did some of the low beta shares such as Edgars, Imperial, JD Group, Pick 'n Pay, Absa, Standard Bank and Nedcor fare so poorly in this market decline?
There are two reasons why resource shares did well:
- The first is that these happen also to be rand hedges (they benefit from a weaker rand) and the rand weakened sharply at the same time as the market was in decline.
As the rand weakened, investors re-calculated the earnings forecasts for resource shares based on a weaker rand and came to the conclusion that they now offer better value than before, because the weaker rand pushes up their earnings (but only as long as the outlook for the commodity prices they are impacted by stays the same).
- The second reason, pertinent to the South African market, is that most fund managers have already had quite a low exposure to resource shares in their funds, with a stronger preference for industrial and financial shares.
Given their underweight position in resources, they looked to the other sectors for shares to sell to reduce their exposure to a falling equity market, resulting in their selling programs putting more pressure on industrial and financial share prices.
Another reason industrial and financial shares suffered more was that they are all impacted by rising interest rates. The recent surprise interest rate hike impacts on the spending patterns of South Africans, and the earnings potential for banks and retailers, as well as local property shares.
Therefore, as the forecasts for those interest rate-sensitive (albeit low beta or defensive) shares were marked down, these shares lost some of their relative attractiveness and were sold down.
Finally, let's examine the defensiveness of gold shares in recent months.
The US dollar and gold and platinum prices have come off their peaks.
During the initial stages of the equity market decline, neither the rand nor inflationary fears helped the gold shares - it is only in recent weeks that they have perked up and started playing their "disaster-proof" role.
During the first few weeks of the market decline that started in mid-May, the problem was that where one may have expected gold shares to perform well, the US dollar instead initially strengthened (possibly due to the expectations for even higher interest rates in the United States) as the equity markets declined - and a strong US dollar is usually not good for the price of gold.
There are some shares that stayed true to form in recent months and provided a little stability and diversification.
Some of these include Remgro, Liberty International and Richemont (the first two classic low beta shares and the last one a "market beta" share - which is neutral to the market).
What do they have in common? They are all rand hedges but they are not resource shares (with the exception of some exposure within Remgro's portfolio to, for example, Implats). In fact, you had a chance to buy Remgro's impressive dividend stream for 14 percent less than the current price just a few weeks ago.
Yes, it does take a lot more than intelligence when it comes to sensible investing. Resolve, staying power and a portfolio built on temperance rather than greed are just a few of the qualities that are needed.
Long-term patterns and relationships often suffer temporarily in short-term market turmoil - this is the time to keep your head and to remain sensible.
Remember that it is hard for resource shares to keep going up when commodity prices turn, regardless of rand weakness, and some of these commodities have pulled back strongly from their highs.
Resist the temptation to make wholesale changes to your portfolio just because the long-term picture has hit a rocky patch.
(Beta research was provided by Cadiz Securities.)
- Anet Ahern is the chief executive of Sanlam Multi Manager International