Sometimes it helps to start by focusing on what something is not. Leaving your cash under the mattress is one of the surest ways to cause a permanent loss of capital. No, not necessarily due to burglary on your premises, but rather the simple facts of economics.
If one works with a long-term average inflation rate of 6%, your purchasing power will decrease by 50% every 12 years. Put differently, the average cost of consumption will at least double over a 12-year period. Why “at least”? Because not everyone consumes the average basket of goods or services. Private medical care, for example, on average increases by around 10% per year – and so the list goes on. A 12-year period is a relatively short time considering such a significant effect on your capital. Einstein said that compound interest (interest on interest on interest…) is the eighth wonder of the world, and his reason was that wealth is created exponentially, not in a linear way. Inflation is also exponential and therefore the effect over a 12-year period is so substantial, albeit in the wrong direction.
If you want to win a rugby game, you at least need to be in the game. Leaving money under the mattress or even just in a bank account, means sitting on the side-lines. If you think “maybe I can sit on the side-lines for a while and re-enter the game when the time is right…”, the problem is that when it comes to investments there is too much evidence that it is not possible to consistently get your timing right and that you most probably will end up chasing your tail as well as incurring unnecessary transaction costs.
The question remains, how do we protect capital? We now know that at least we need to be in the game and grow our assets in tune with inflation, but we still need to know what is necessary to at least grow them at the same rate as inflation. The two goal posts for which you have to aim are adequate diversification and paying the right price. They have to be considered together and require a balancing act when aiming to create an all-weather portfolio, allowing you to play well at Newlands and at the Hage Geingob Stadium.
Adequate diversification means that you don’t place all your eggs in one basket. If you want to invest in businesses it would be wise to invest in 30 stocks, for example, not just one. This also means that it might be wise to spread your capital across different geographies and/or sectors.
The goal post of paying the right price reminds you that you cannot just buy something without considering what it is worth. Those who fly with Westair frequently may have read the article on Investing against Emotions. It refers to the emotional rollercoaster of economic cycles and where humans tend to inflate or deflate the prices of assets based on perceptions of the time.
The often reckless geographical allocation calls that investors make are a very practical example that is close to home. Ten- year government bonds in the developed world, for example Germany and the Netherlands, currently have negative annual real returns (after deducting inflation) for 10 years. In simple terms this means that you are paying those governments money to borrow money from you – ludicrous!! The cyclically adjusted S&P 500 Index in the USA is trading at rarely seen expensive valuation levels. The only other years that stand out in this respect are 1929 and 1999. When you have time, ask Google to remind you what happened next. What goes up must come down. Real yields achieved, for example, with 10- year South African government bonds are ±5%, already taking very dire economic conditions into account and providing you with a margin of safety. Parts of the Johannesburg Stock Exchange are on auction for less than during the financial crisis of 2008/2009. Locally, the returns of certain money market funds are between 3% and 4% above inflation.
This article by no means aims to provide advice on specific asset categories or geographies, as we are all different and our specific circumstances need to be considered carefully. However, these goal posts remind us that we need to carefully consider the playing field before we play (invest). Yes, we need an all-weather portfolio invested in different jurisdictions, but we cannot just do it at any price – or did we already forget about our own recent property bubble that burst some of our capital permanently?