The risk paradox

Everyone knows that when investing, there are two clear things to consider – risk and reward. Modern portfolio theory tell us that, for an adequately diversified portfolio, the higher the risk, the higher the reward, and vice versa.

The efficient frontier

Economists and financial analysts typically represent this idea on what is called an efficient frontier. Cash and fixed-income asset classes represent a low-risk, low-return portfolio, while asset classes like equity and global equity represent their high-risk, high-return counterparts. Most other asset classes and portfolios, like balanced funds, are generally somewhere in between on this risk spectrum. The efficient frontier maps out all these options in the risk-return space.

During market crashes, like the financial crisis or the current COVID-19 pandemic, we tend to see a flight to safer assets. Across the globe, investors switch out of volatile asset classes (like equities) in favour of more stable, safer asset classes (like cash and fixed income) while new money is allocated to cash as well.

For example: On 31 March 2020, the collective investment scheme industry in South Africa lost about R25 billion in equity flows as the coronavirus cemented global market uncertainty. In comparison, the interest-bearing sector and income sectors attracted R67 billion in yearly flows. Naturally, investors are nervous.

 We have also seen extreme market turbulence over the last decade, like:

·        The European sovereign debt crisis in 2011

·        The global market selloff in 2015

·        The negative emerging market sentiment in 2018

·        The recent lockdown in 2020.

When we look at the market turbulence, it’s tempting to allocate our savings on the efficient frontier to asset classes that will reduce the wild swings of the market, like cash. Stability, certainty and conservatism prevail – but is this correct?

The paradox

Ironically, the efficient frontier is probably less relevant to our decisions than we may think. Money market and cash assets are less volatile than equities, but this is only true if your investment time horizon is short and you have no investment goal.

For most investors, however, savings terms are many years or decades and they have specific goals, like retirement income, their children’s future education or a bequest motive. What we think of as ‘less volatile, conservative assets’ will most certainly not meet our goals, while equities and the like have a much higher likelihood of giving us the outcome we need.

 When we look at risk and return through this lens, we see a different story altogether. Cash becomes the riskiest place to put your money as it is almost guaranteed to underperform, whereas ‘riskier’ asset classes (like equity) become the most likely to meet our long-term objectives.

 In short, the efficient frontier inverts itself as our investment term increases.

Convergence happens over the long term

While equity returns become the most suitable for longer-term investment returns, it’s interesting to see that as the investment term increases, the stability of equity returns increases as well.

Looking at the South African All Share Index as far back as 1995, we see the numbers telling this story. For a short-time horizon of two years, the top quartile of returns was 25% per year, and the bottom quartile was 4%, with the median at 13% – quite a substantial difference. Pushing the term out to 20 years gives an entirely different picture. The top quartile of returns measured over this time horizon was then 15% per year and the bottom quartile was a very comfortable 14% per year. This is an almost unnoticeable difference. In fact, an equity investment in the All Share Index would never have lost money over any chosen period of six years or more in the last 25 years, no matter when you choose your start date. This includes all the market crashes, all periods of heightened volatility, downgrades and all the political drama we’ve experienced. Of course these returns should be inflation-adjusted, but it is clear how much the returns converge over the long term.

This risk paradox tells us that investing over the long term is not really about taking higher risk to get higher returns, but in fact quite the opposite. When correcting for the term of the investment, it’s actually always about reducing your risk of not meeting your outcomes. Importantly, this reduction in risk doesn’t necessarily mean investing in cash. Rather, it means redefining what risk means – appropriately depending on your investment term and your goals.