Earlier this year, I weighed up the benefits of lump-sum investing versus splitting your investments over a period of time. I looked at the risks associated with both approaches and concluded that lump-sum investing works best in a bull market, while it is more prudent to stagger your investments when the market is moving sideways or declining.
Clearly, with hindsight, you should have put every cent of your spare cash into the local equity market at the beginning of 2005 and never spared it another thought for the rest of the year.
The problem is that it is difficult to predict the behaviour of the stock market. Bull markets tend to be characterised by phases in investor psychology. Some of these phases include disbelief, reluctant acceptance, selling some shares only to buy back higher and, finally, total surrender. It is at the total surrender phase that most investors get caught. This is when investors throw caution to the wind and risk analysis attracts about as much attention as a 2am talk show on the environmental benefits of using Tupperware instead of Glad Wrap.
Perhaps we are not quite there yet. After all, the economy appears to have entered a period of apparently unstoppable growth.
However, it is time to take another look at risk. By risk I mean the possibility of losing your capital. This risk is most important when you are considering fresh inflows into the equity market at this point. If you have been investing for some time, are taking a longer-term view and have built up a buffer of profits from your initial investment, you may have more tolerance for the possibility of a bumpy market.
But if you have been sitting on the sidelines or are considering committing a further amount to the market, you should be aware of what has happened to investors' views on risk worldwide.
A feature of this year around the world has been the narrowing of the risk premium attached to investing in developing markets versus developed markets. Investors attach a value to the risk they associate with investing in a particular asset. They want to get an extra reward for taking on extra risk.
Often, risk appetite can be seen in general terms. In other words, if investors are prepared to take on more risk, they tend to do so across asset classes. Therefore, looking at the bond market is a useful way to assess investors' attitudes to risk even when talking about equities.
Let's cast our minds back to 1998, that awful period of emerging market crises and soaring local interest rates. In South Africa, short-term rates went from 18.25 percent to 25 percent in the space of a few months. The stock market plummeted 40 percent between May and September of that year. During that time, investors demanded to be paid yields of some 12 to 15 percent more when investing in emerging market bonds compared with developed markets.
The Emerging Markets Bond Index (EMBI) spread, which measures the difference between the rates offered by bonds in emerging markets and those in developed markets, was over 12 percent at the beginning of 1999. This reflected a high level of caution among investors, to say the least. That same EMBI spread is now 2.5 percent.
What has happened to cause this?
Increased appetite for risk
Firstly, many emerging countries have addressed some of the structural issues, such as foreign debt and political instability, that were making them more risky. Brazil comes to mind as an example.
Secondly, as interest rates declined in developed markets, particularly in the United States following 9/11, investors struggled to find attractive income yields and this led to more investment in emerging market bonds, driving long-term rates lower. The general trend of lower interest rates globally also enabled developing countries to lower their short-term rates, fuelling economic growth.
Investors tend to invest for two main reasons: yield and/or growth. Over time they will show a preference (however marginal) for one or the other. As yields come down, they tend to shift their emphasis to growth areas. Often, they first chase yield, then switch to growth when the yield quest has been exhausted.
This combination of rates being driven down and economic growth picking up leads to a renewed interest in equities. And that is what we have seen this year. In US dollars, emerging markets have shown a return of 18 percent over the past 12 months. This compares with a return of four percent from world equity markets. Japan has been the exception among developed markets, moving up strongly this year.
Recently, developed markets have caught up a little, narrowing the return gap somewhat. However, among the 80 constituents of the Morgan Stanley World equity index, there have been moves in excess of 60 percent for the year to date in emerging markets such as Dubai (188 percent!), Saudi Arabia, Kuwait and Sri Lanka. There is no doubt that developing countries are different now compared with a decade ago. The question is, at what point are investors no longer being compensated for the risk of investing in them?
How does all this affect you, the South African investor?
One of the reasons our equity market has performed beyond most people's expectations is the renewed interest in emerging markets and the increased appetite for risk - inflows from foreign portfolios have helped to raise prices.
Should emerging markets take a breather, perhaps because of higher interest rates globally, this could put the brakes on further gains in market. Given the underlying strength of the local market, this downturn may be a temporary phenomenon, but you may want to
prepare for it.
An approach that works for me is to make a standing contribution to the market every month. If any part of the market in which I have been investing seems very high or if I think the risks are increasing, it is simply a matter of switching any new contributions to an area that may offer more value or that has lagged, but which fits into my overall portfolio strategy - whether it be cash, offshore markets, hedge funds, small caps or property. You don't sell the investments you have already made; you just divert your cash flow into other areas.
When I asked a very wise mentor early on in my career how he became so wealthy, he responded that he did it by thinking carefully, buying well and never selling a single share. He believed in taking a long-term view, buying quality investments and hanging on to them for the long-term compounding ride. It worked for him.
If you make a regular contribution, you can derive the maximum benefit from compound growth by diverting flows rather than selling out of your investments. In this way you manage the risk in your portfolio with relatively low disruption to your overall investment plan.