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EDINBURGH — Gerbrandt Kruger is one of my favourite bloggers on BizNews. He is an expert with the rare ability to translate benign numbers and unwieldy financial concepts for us ordinary people who just want a better understanding of how best to manage our money and build wealth. In this piece, he demonstrates the importance of minimising investment loss in order to achieve superior returns in the long-term. Gerbrandt has produced a handy table that illustrates how compound interest works against us when we lose money. The numbers are scary. Look at how much harder your money has to work as losses increase – just to break even. – Jackie Cameron
By Gerbrandt Kruger*
One of the many pearls of wisdom dispensed by Warren Buffett is “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”. Unfortunately this is easier said than done in the real world. Fund managers are acutely aware of investor aversion to losses.
Losses on portfolios can be due to market movements in the price of the investments or when investments go under or default on their obligations. The latter is permanent capital loss, as there is no opportunity to recover the losses suffered. African Bank is an example of this. Investors may get some of their capital back, but will unlikely get a material portion of it back.
When suffering losses, an investor requires a return higher than the loss to return to breakeven. The graph below shows the subsequent required return needed to breakeven for a particular levels of loss.
From the above graph we can see that the breakeven return required grows exponentially as losses increase. When investors suffer a 10% loss, they only need 11% to get back where they were. At a 50% loss the investments needs to have subsequent return of 100% to breakeven.
Fund managers have different ways in trying to minimise possible capital losses. If the fund manager is managing a multi asset class fund he/she will be able to underweight or avoid asset classes that are expensive (high in risk) and rather allocate capital to asset classes that are cheap (low in risk).
An active fund manager can also try to reduce possible losses by individually picking the instruments he/she wants to include in their portfolio. They can select the companies that are undervalued and avoid ones that are expensive.
No fund manager is exactly alike and each has a different way in classifying risk and varying levels of risk aversion. The more aggressive fund managers will tend to outperform a conservative manager at the end of strong bull market. In bull markets a conservative manager will typically start taking profits from the stocks that performed well and deploy the capital into asset classes where there are opportunities.
The aggressive manager will tend to ride the run as far as possible and will experience a bigger drawdown when the markets correct. Managers that avoid deep drawdowns typically perform better over full market cycles.
The graph below is a drawdown comparison between two funds (blue and green) and the category’s average fund (yellow). The blue line is a typical conservative manager and the green line a more aggressive manager. Both of these funds fall into the (ASISA) South African MA High Equity category.
Source: Morningstar Direct
During the financial crisis of 2008 the blue fund manager was able to protect capital much better than the green fund. The maximum drawdown of the blue fund was 11.8% compared to the green’s 23.4% and the average manager’s 16.8%.
This is one of the reasons one should take time to understand a fund manager’s philosophy and investment process. You might just be able to spare yourself some heartache by avoiding making an investment with an aggressive fund manager at the peak of a market cycle.
At Seed we understand that risk needs to be taken to generate inflation beating returns, but seek to structure our solution Funds (Seed Flexible and Seed Absolute Return) in order to ensure that they don’t experience permanent capital destruction.
- Gerbrandt Kruger graduated from the University of Pretoria at the end of 2007 and is currently completing his actuarial exams. He has experience in Financial Modelling, Finance and Financial Reporting, Probability, and Mathematical Statistics. Gerbrandt spends the majority of his time developing software systems for research purposes, performing research on local hedge funds, and manages due diligences. Gerbrandt is a risk manager at Seed Investments.
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