Source: Financial Times/www. ft.com as at 4 January 2013

They say a picture is worth a thousand words – this one has proven to be worth a few thousand Rand too.  

My godson, Steven, turned 10 years old in July of last year and other than being very proud of the young man he is growing into, he also has a valuable investment message for us, even at his young age. Steven’s time in this world overlaps quite nicely with the above graphic, which represents the price return of the South African JSE All Share Index over the last 10 years.

I mention Steven, as in lieu of purchasing a gift for his Christening, I put a couple of thousand rand into a passive SA Equity tracker fund for him in early 2003.

As of January 2013, Steven’s passive investment in the JSE All Share has grown by about 420% – this works out to around 18% each year for his 10 years. That is a brilliant real return which should make any investor very happy. This is even more impressive in the context of a South African equity market which has averaged a 12.5% return since 1900. (Source: Credit Suisse Global Investment Yearbook 2012)

With the benefit of hindsight, it seems to have been a no-brainer to have re-mortgaged the house and invested the proceeds into the SA equity market over this period. (Preferably in a heavily leveraged manner too if possible) However, without the advantage of hindsight or a crystal ball, accurately predicting or forecasting future market returns is improbable, if not impossible. Added to which, if we scrutinise this 10 year performance over shorter time periods, it becomes apparent that there is typically a lot of ‘noise’ that provides investors with plenty of opportunity to complicate matters. Most of the time this complication is achieved by trying to time the market, usually heavily under the influence of emotional duress.   

For example, by the time the market peaked in May 2008 at 32700, Steven’s investment would have gained 320%, representing an annualised return of 33% a year. Sheer genius results even for investors of the calibre of Warren Buffet. This would have been a great time to book profits in hindsight, especially since we now know that we were on the cusp of the Global Financial Crisis (GFC) and the collapse of Lehman Brothers late in 2008. In reality however, if Steven was trading rather than investing, he would most likely have booked a 100% gain sometime in 2006 as he had doubled his money and would have lost out on the additional returns or at least some of them.

From the peak in May 2008 to the trough in November 2008, the JSE All Share index lost almost half of its value or 45%. The world as we knew it was ending.  Banks were literally collapsing, companies were unable to access any funding and the prospect for the future was as bleak as it had been during the Great Depression. I was working in London at the time and can vouch for the panic that dominated the actions of private clients, institutional clients and professional investors alike during this time. Many investors sold out at or near the lows as the carnage became too much to bear. Many of those who sold out then failed to re-enter the market on the uptick which means they exacerbated their position by failing to participate in the approximate 123% gain since 2008. If Steven was trading rather than investing how would he have fared facing these fluctuations? Probably not as well as we would like to believe.

Under a scenario of perfect market timing it is true that Steven could have sold at the high of around 32700 on the index in May 2008 and then reinvested at the lows of around 18000 in November of 2008. His returns today would have been closer to 843% or a whopping 25% annualised return over 10 years. I am not aware of a single investor or trader who managed to trade the crisis with that level of success.

The irrational behaviour we display as human beings when trying to time markets is based on what seems like a very rational thought process at the time. When markets have delivered strong returns, it is usually on the back of a recent period of strong earnings growth from companies, which translates into higher share prices.  This strong earnings growth gets extrapolated into the future and so we tend to expect equity returns to continue to power forward and are therefore more likely to be buyers at new market highs rather than sellers. Conversely, when markets are selling off, as during the 2008 period, we tend to also extrapolate these losses into the future and thus sell at or near market lows when everyone else has finally capitulated and are also selling.

These market inefficiencies are mostly caused by emotional-driven investing and are easy to identify in hindsight but nearly impossible to identify in the heat of the moment. We are therefore likely to continue to witness similar market swings in the future.

Personally when I look at the graph above, and consider the uncertain macro-economic environment in which firms currently have to operate, I feel a great sense of unease going into 2013. I would not be surprised to see a strong pull back from these levels and with my ‘Traders-hat’ on I would be tempted to lock in profits here and look to re-enter at cheaper levels.

Trading can certainly have its place in your financial plan – if you stayed invested in the S&P500 over the 9 years preceding the end of 2011 your price returns would have been close to zero, but there would have been huge fluctuations within that period. If you opt to go the trading route you must be clear about your objectives and you must operate within a defined and disciplined process to be successful. You must also accept that you will incur higher trading fees and be subject to more taxation as a result of your activity.

Steven, on the other hand, is an investor. He has held this investment throughout the 10 year period and will hopefully continue to do so for at least the next 8 to 10 years. Of course Steven has not actively been monitoring his investments over the entire period but I can assure you that he is aware of the existence of the investment and has a better understanding of the principles of investment as a result.

Steven has, perhaps somewhat inadvertently, displayed the characteristics integral to creating wealth that we as adults often battle to master – Patience, discipline and unemotional decision making. If Steven continues to display this attitude in his approach to investing as he grows older, his chances of creating real wealth or ‘striking it rich’ will be much improved.

Increase your chances of investment success:

Set a goal with a specific objective and time horizon.

Plan and implement a strategy to achieve that goal.

Make sure you decide upfront whether you are investing for the long term or actively trading under this strategy. Your activity will differ significantly under the two approaches.

If you’re an investor with a long term time horizon, try and avoid changing your strategy on the basis of emotional decisions in response to market fluctuations. The strategy is there to protect you from your emotions – remain focused on the long term.

Please note that this article does not constitute advice. If you would like to start investing for your future, consider partnering with White Investments who will help you identify a strategy for long-term success.