Risk & return – both are important

Risk and return are inextricably linked. If you want a higher return, then you need to take on a greater measure of risk.

As investors, it can be tempting to look at another portfolio’s historical returns and believe that this is the portfolio you need. And more importantly, would remain committed to during bull and bear cycles.

Recently a client queried why we don’t use an index fund his friend had recommended rather than the active fund he was invested in, as the long-term return was “much better”. For this article, the “proposed fund” is called the “Index High Equity”.

The risk/return statistic below is an almost 10-year track record from 1 January 2008 to 31 December 2017.

The existing fund, Allan Gray Balanced, generated a slightly lower annualized return than the Index High Equity. Thus on return alone, the proposed fund outperformed.

When you do a little homework you will realize that the Allan Gray Balanced Fund generated almost the same return, with lower levels of equity, less monthly volatility and a significantly lower maximum drawdown.

During the 2008 global financial crisis, the Allan Gray Balanced Fund was down -10.79%, whilst the Index High Equity was down -24.57%. We know that most clients will struggle with a decline of this nature, the majority start to panic at -10% to -15%, and thus would likely not have received the full annualized return of 11.09% as they are likely to have switched into cash when the losses started to accumulate, thus eroding their long-term returns.

This isn’t an article about the merits of active versus passive, but rather about making sure investors are aware of the risk involved with their portfolios, and ensuring all decisions are based on evidence as opposed to feelings and emotions.

If we focus on the return alone we lose sight of the potential risks inherent in a particular investment, which may affect the chances we will remain invested during volatile periods.