Concepts which drive investor outcomes over the long term - October 2018

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Coronation Insights

Coronation Insights

THE POWER OF COMPOUNDING

The power of compounding is critical to long-term wealth creation. Compounding is the process in which an asset’s earnings, from either capital gains or interest, are re-invested to generate earnings over time. To highlight the effect that compounding has over long periods of time, consider the charts below.

Figures 3 and 4 illustrate how much an investor would need to save at a given starting age in order to have a R1m at the age of 65 at a 10% p.a. return.
Figure 3 indicates the lump sum investment required, while Figure 4 provides the monthly amount required.

FIGURE 3 - THE POWER OF COMPOUNDING


FIGURE 4

The important point to note is the significant benefit of saving earlier due to compounding of returns. A 20-year-old investor only needs to save a little over R11 000 in order to reach their R1m goal at retirement, whereas they would need to save nearly three times as much when they reach the age of 30.

TIME DIVERSIFICATION

A long time horizon allows investors to take greater risks - making it possible to have more exposure to growth assets with higher expected returns and the attendant variability from year to year.

In The Effective Investor (Pan Macmillan, 2009), Franco Busetti writes that ‘after compounding, time diversification of risk is your second-best friend in the market’. The concept of time diversification refers to the decrease in risk of holding growth assets as an investor’s investment time horizon increases.

Take for example an investment in equities. Given the volatility inherent in this asset class, the possibility of suffering a capital loss in any one year is far greater than if you were invested in cash or bonds. However, the longer the investment period, the lower this variability becomes.

Figure 5 below shows the odds of losing money invested in the FTSE/JSE All Share Index over different investment time horizons (rolling 5, 10, 15 years, etc.). Using returns from 1960, the likelihood of losing capital diminishes drastically as your investment horizon increases to the point where one has never had a negative return over a 5+ year investment horizon.

FIGURE 5 - ODDS OF LOSING MONEY IN THE JSE ALSI (1960 - 2018)

ASSET ALLOCATION AND DIVERSIFICATION

Investors also need to be aware that investment markets are not static. New opportunities arise as companies, industries, countries and asset classes develop and contract. Relative valuation levels between local, developed market and other emerging market assets, as well as between equities, bonds and cash, change over time. The emergence of new asset classes such as inflation-linked bonds, or a deepening of an existing asset class through new listings and more activity (as was the case in the domestic listed property market) add to the investable universe. Regulations that restrict or enhance the freedom to invest in foreign markets may also change. Investors can therefore enhance their eventual outcomes by making good strategic and tactical asset allocation decisions in response to this dynamic environment.

While equities typically have the highest expected return over time (as we will illustrate here), this is not always the case. Market price levels can change both for fundamental (sustainable earnings and dividend growth) and sentimental reasons (investors in aggregate are more/less optimistic and hence prepared to apply higher/lower ratings to companies). This insight supports the use of a strict valuation discipline when deciding what the optimal portfolio structure should be, informed by the difference between current price levels and well-considered long-term fair values in different markets.

Figure 6 below illustrates how the asset allocation of our flagship balanced fund, Coronation Balanced Plus, has changed over the past 10 years.
The stand-out features are:

  • Our comfort with temporarily holding relatively high levels of cash at times when we believe valuations to be stretched in higher return/higher risk alternatives such as bonds, property and equity; and
  • The increase in offshore equity exposure over time, primarily at the expense of local equities. This trend was partly due to regulatory action, as exchange control limits were gradually relaxed to the current 30% foreign asset limit, but more importantly, driven by the more attractive relative valuation of global compared to local shares at certain times.

FIGURE 6 - ASSET ALLOCATION FOR CORONATION BALANCED PLUS