By diversification we mean including asset classes in a portfolio that reacts differently to prevailing market conditions. By diversifying in such a manner, we can expect higher probabilities of beating infl ation than would otherwise be achievable.

A historical review of the returns of the major asset classes (local equity, international equity, local bonds and local cash) since 1960 shows us that diversifi cation has indeed benefi ted investors. First, let us consider the performance of these asset classes individually. The table below shows the annualised return above infl ation and the risk (risk or volatility being a widely accepted statistical measure of the degree of variation of return) of each of the asset classes over the 47-year period starting in 1960. In this example we have not taken costs or tax into consideration.

One can immediately see that local equity, while providing the greatest annualised return (8.9% pa above infl ation) over the period, also appears to be the riskiest. International equity has produced returns of 7.2% per annum above infl ation (in rand), with slightly less risk than local equities. Local bonds have produced the lowest return over the period (1.8% pa), while local cash has been the least risky asset class. Inflation has been 8.5% pa, on average, over the period.

We are also able to calculate how often the individual asset classes outperformed inflation over various time periods. The table on the left gives the percentage of periods that each asset class has outperformed infl ation. The final column in the table shows the success rate for typical diversified portfolio consisting of 60% local equity, 15% international equity, 15% local bonds, and 10% local cash that has been re-balanced monthly.

From this one can see that over any one-year holding period, local equity has a 67% chance of outperforming inflation, while over any 10-year holding period, this increases to 95%.

Some very clear trends emerge from the data at hand:

• The higher risk asset classes (local and international equity) offer a greater chance of producing inflation-beating returns than lower risk asset classes (bonds and cash), except over one-year periods. In terms of what investors’ true objectives are, it therefore appears that the existing defi nition of risk is misleading, as the asset classes that are conventionally  understood to be the ‘riskiest’ actually have the highest probability of outperforming inflation over all but the shortest periods.
• As the investor’s time horizon increases, higher risk asset classes have a significantly improved chance of beating inflation, while lower risk classes have worsened chances.
• For all periods greater than one year, the chance of the diversifi ed portfolio outperforming infl ation is at least equal to, or better, than the chance that any individual asset class will beat inflation. This means that one can use assets that individually have lower probabilities of beating inflation to construct a portfolio that has superior inflation-beating characteristics. This is diversification at work.
• Costs obviously have the ability to erode the likelihood of success. We calculate that costs of 1.5% per annum would reduce the chance of success by 3-4% for the diversifi ed portfolio.
• Income and capital gains taxes also have the ability to erode the chance of success. Cash and bonds are taxed far more punitively than equities. The table on the left highlights this fact dramatically.
• We have calculated that at a 30% tax rate, the likelihood of success for cash to beat inflation decreases by over 30% and for bonds in the region of 15% over the various measurement periods. The diversified portfolio only decreases by 2-3%. This highlights very clearly the fact that taxpayers potentially need very different asset mixes to non-taxpayers, as the likelihood of success on an after-tax basis is dramatically linked to the tax treatment of the assets included in the portfolio.

Investors have different objectives, but achieving infl ation-beating returns is still the top priority for most. Although we can’t necessarily expect history to repeat itself, we can certainly take note of the lessons that it teaches us. In this instance, it is clear that diversification has been a highly effective tool to increase the likelihood of consistently outperforming inflation. The effect of costs and taxes on the likelihood of success also needs to be clearly understood.

(Article supplied by Nedgroup Investments;
Contact: Matthew de Wet, Head: Investments,
Nedgroup Investments, tel. 021 416 6085,
and Marina van der Lith Nedgroup Marketing,
021 416 6033, cell 083 325 0428).