Question:
I am extremely freaked out by the bankruptcy of Lehman Brothers and the ensuing carnage on the JSE. It seems like it's the only subject being discussed at work, but no-one knows what to do about it.

Please can you help? Should we sell our shares and invest in something safer? Or will this blow over?

What would you be advising your clients that might share my concerns?

Answer:
Without any doubt, the global market reaction to the Lehman Brothers collapse last Monday has left most of us with some worrying questions. These latest developments have had the biggest impact on US markets since 9/11 and many global markets have followed suit. Although the nature of this crisis may be new and unusual, the motivation behind investors’ reactions is not. Quite simply, the one question that drives our reactions more than anything else is whether our money is safe.

Understanding how most of us see risk

In general, people tend to greatly overestimate or misunderstand the potential risks associated with share market (generally referred to as ‘equities’) exposure. Over the long term (for investment terms greater than 10 years), this risk does not, historically, exist. While it is certainly possible that we can suffer short-term risks by being invested only in equities, this risk is irrelevant over the long term. If we look at any given 10-year period in the last hundred years, South African equities have never given us a negative return. They have also, on average, outperformed other South African asset classes over this period.

Risk and volatility are different things

This is where most of us tend to miss a fundamental truth: volatility — basically how much an investment goes up and down — is not risk. This is an important distinction because volatility is what we need to make money from investments. As the price of something comes down, we can buy it so that we can later sell it when it’s more expensive. The difference is the profit or the growth — the reason we invest in the first place. Most South African equities were relatively cheap before news of the Lehman Brothers hit. They are now even cheaper. In a way, the South African share market is actually having a big sale at the moment and long-term investors stand to benefit.

As equity investors, we must be prepared to see share prices go both ways over the short term. Investor uncertainty, however, pertains to risk. This is the chance of your money being worth less. In a properly diversified portfolio, volatility is not risk. It’s just volatility.

When does volatility become risk?

So, what does the typical risk profile of an aggressive (share-based) investment strategy look like?

Over a one-year term, we can expect to make about 50 percent at best and lose about 25 percent at worst. Over time, the average best and worst returns per year become less extreme when seen against the original investment. We then eventually reach a point where our chance of a negative return falls away altogether.

Risk only exists if you decide to cash in your money during the period in which you stand to realise a loss. It is important to realise that volatility in this period only becomes risk (actually losing money) if you move your money and realise the loss at the time.

The greatest risk you expose yourself to when you move your money is opportunity cost. An investment strategy does a very simple job. It provides a way for us to make our money grow at the rate we need at the lowest possible level of risk. In the long run, a ‘riskier’ investment strategy will outperform a ‘safer’ one. By switching to a ‘safer’ strategy now, you are merely substituting volatility risk for the risk of not achieving your goals or even beating inflation over time.

Dealing with our impulse to flee

As investors, we need to understand that there is only one way in which we can turn volatility into risk: by withdrawing capital. This is easily overcome by doing a simple thing: DON'T DO IT. But if you have to, limit this only to that portion of the investment that is absolutely necessary. Because, no matter what you hear, this time is not different from all the previous crises. And in all the previous times, those who chose to flee when prices fell and bought when they went back up were worse off in the long run. Every single time.

Are you confused about the Lehman Brothers fiasco and what it might mean for your investments? Read 'Lehman Bros 101' for a clear and complete analysis by acsis.

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