Whenever you read anything about investing you hear words like volatility, risk and growth assets but how exactly does this affect your investment returns?

There are two types of investors: one group is very risk averse and prefers to stick to cash-like investments even for long-term savings. Another group fully believe in the high-risk, high-return model.

The problem is that both principles have their downside. An investor who is too cautious may find that their investment does not keep up with inflation while a higher-risk investor does not always fully understand that risk means there is a very real chance you will lose your money – when that happens they often sell out at exactly the wrong time.

The graph below, which Coronation kindly complied for this article, is an excellent illustration of the relationship between volatility (risk) and growth over time.

The graph compares the relative performance of three Coronations unit trust funds with varying risk profiles over the same investment period. It also includes the returns from the JSE All Share Index (ALSI) as well as cash for the same period.

Low risk, low return

Coronation Strategic Income is a low risk fund which invests in cash-like investments with the aim of marginally outperforming cash over time. There is no volatility in this fund, meaning that the unit price rises steadily over time with no surprises either on the upside or downside. If you had invested R100 000 eleven years ago it would be worth R336 972 today. While that may sound like a lot of money, due to the effects of inflation over time, you would need to have around R250 000 today in order to buy the same goods and services as R100 000 bought you in 2001. So in fact your “real” return is only around R86 000.

Medium risk, medium return

The Coronation Balanced Plus is a medium risk fund which meets the prudential guidelines for retirement savings. This means it can be used for a retirement annuity and it invests in a range of assets including cash, bonds, property and equities (shares). As you can see from the graph there is some volatility, in other words the unit price does rise and fall along the curve.

Investors who could live with the volatility and did not cash in their fund when the market fell, would have received a total return of R513 787 over the eleven years, more than 50% higher than an investment in the Strategic Income Fund.

In fact during any period after the first five years an investor in the Balanced Plus Fund received higher returns than an investor in the Strategic Income Fund. This is why it is always recommended that if you have an investment horizon of more than five years you should consider a fund that invests in higher risk growth assets.

However for an investor with a shorter time frame the results are very different. During the first four years of the investment the Balanced Plus Fund under-performed the Strategic Income fund. In addition the fund fell by 20% during the financial crisis while an investor in Strategic Income would have seen a steady rise. A short-term investor would have experienced a loss during this time, however if the investor stayed invested in the Balanced Plus fund their investment would have recovered by August 2009.

What is interesting to note is that the Balanced Plus Fund delivered the same return over the period as the average performance of the JSE ALSI although with slightly less volatility. It did not reach the same peak as the JSE ALSI in 2008, but nor did it fall as much in 2009. This is due to its diversification into other asset classes such as bonds, property and cash.

High risk; potentially higher returns

The Coronation Top 20 is a high risk fund as it invests only in shares on the JSE and limits its choice to the fund manager’s top 20 stocks.

As you will see from the graph the volatility is substantially higher than the Balanced Plus Fund. During the crisis an investor would have seen their fund value fall from R503 000 to R355 000 over two years, representing a 30% “loss”.

However if the investor had not panicked, understood the nature of the fund and held their position, they would have seen a recovery within five months of the bottom of the market and would today have received a total return of R784 900 from their R100 000 investment eleven years ago. That is a massive R447 928 more than the same investment in the Strategic Income Fund and R271 113 more than the Balanced Plus Fund.

Your investment choice matters

This graph demonstrates the immense power of the stock market over time but it also highlights its risks over shorter periods.

If you are investing for more than five years you would be giving up on potential returns by being too conservative. However if you are tempted to invest in the highest risk fund you need to fully understand the meaning of risk.

If you had invested in October 2007 at the very peak of the market and then watched your life saving collapse by 30%, would you have had the resolve to stick with your original decision knowing that you had at least five years to recover? If you had, you would have been rewarded, but if you had panicked and sold at the bottom of the market you would have realised your losses and would never be able to recover that money.

For some people the idea of their savings falling by such proportions may be too much to bear and in that case it would be wiser to take a more pedestrian approach and select a fund with lower volatility (risk) so you do not risk a knee jerk reaction which sees you selling at the worst possible time. But at the very least, be very careful of investing in low risk, cash-like investments for too long – you are giving up way too much potential return and face the very real risk that your money will not keep up with inflation making your poorer.

NOTE FOR GRAPH:

R100 000 invested from June 2001-July 2012
Coronation returns are net of fund management costs, but not advisory fees

This article first appeared in City Press