The case for being patient - October 2019
Investors looking to achieve long-term capital growth have one great advantage − time. When you are investing to fund a long-term objective such as your retirement, your investment time horizon spans decades rather than years. This allows your investment portfolio to benefit from the key drivers of capital growth.
DRIVERS OF LONG-TERM CAPITAL GROWTH
1. The power of compunding
Critical to long-term wealth creation
Compounding is the process of re-investing an asset’s returns (from either dividends or interest), which creates a larger base from which you can earn returns in the future. As a result, compounding is an exponential rather than a linear function, so the longer you have to invest, the greater the possibility of dramatically multiplying your purchasing power.
Let’s consider compounding’s extraordinary power with an example. Thando starts to invest R500 a month at the age of 25. She contributes the same amount monthly for a period of 10 years, with her investment growing at a rate of 10% a year. After 10 years, she stops contributing on a monthly basis and simply allowsher investment to grow until her retirement age of 65.
John also invests R500 a month, but only starts 10 years later than Thando (at the point where Thando stops her contributions). He then continues to contribute that same amount diligently until his 65th birthday. His investment also grows at 10% a year.
WHAT HAS MADE THE BIG DIFFERENCE FOR THANDO?
The important point to note, as illustrated above, is the significant difference between the end values for Thando and John. At 65, Thando (who only contributed for a period of 10 years and then left the investment to compound over a period of 40 years), had accumulated an amount of more than R2 million. At 65, John (who contributed three times more than Thando) onlyaccumulated half the end value of Thando’s investment.
2. Time diversification of risk
The benefit of lengthening your time horizon
‘After compounding, time diversification of risk is your second-best friend in the market,’ writes Franco Busetti in The Effective Investor (Pan Macmillan,2009). Put simply, time diversification means that the longer you hold a
growth asset (such as equities), the lower your risk of losing capital becomes.
Consider an investment in equities – the asset class that provides the highest expected return over time, but with higher short-term volatility. The chance of losing capital in any one-year period is much greater than that of an investment in cash or bonds. However, the longer you remain invested in equities, the lower this variability becomes.
R1 committed to local equities almost 90 years ago = R579 today. R1 committed to local bonds and/or cash over the same period = R1-3 today.
Figure 1 shows the odds of losing money on an investment in domestic equities (as measured by the FTSE/JSE All Share Index) over different investment time horizons (rolling 5, 10, 20 years, etc.).
3. Asset allocation and diversification
The benefit of makig good strategic and tactical decisions
Investors in balanced funds, or those who have the skills to perform the asset allocation themselves, can enhance the eventual outcome of their savings by making good strategic and tactical asset allocation decisions in response to the dynamic market environment, which may include:
- new opportunities arising as companies, industries, countries and asset classes develop and contract;
- changes in relative valuation levels, both within and between asset classes over time;
- a growing investible universe thanks to new asset classes (e.g. inflation linked bonds);
- the deepening of existing asset classes (e.g. new listings and more activity, as was the case in the domestic listed property market); or
- changes to regulations that restrict or enhance the freedom to invest in foreign markets.
Figure 2 (overleaf) illustrates how we have used the above tools to add value through active allocation in our flagship balanced fund, Coronation Balanced Plus, over more than a decade. 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.
4. The value of active returns
*Alpha Industry term for the difference between the return of an actively managed fund and that of the market index. Zero alpha means the earned return = that of the market
Investing with a skilled fund manager, which actively manages your portfolio, gives you the opportunity to add alpha*, which can add significantly to your investment over time.
Coronation, like all active managers, pursues the outperformance of market indices or benchmarks (net of the fees we charge and costs that our portfolios incur). In Figure 3 we illustrate the rewards of adding an active return to that of the market by having remained invested with Coronation over the long term. An investment in the local equity market more than 20 years ago would have grown your capital by a little over 15 times (in nominal terms), whereas a similar investment in the Coronation Equity Fund, which has outperformed the market by 2.5% p.a. after fees (a seemingly small number), would have grown your capital by just over 26 times.
The conclusion is as simple as it is compelling. Invest in the equity markets for long periods of time, stick with winning fund managers for the long haul, and the power of compounding will most likely do extraordinary things for you.