Preserving capital in pursuit of good long-term returns

Many years ago, Behavioural Science researchers discovered a bias in the way investors behaved during phases of investment losses versus investment gains. Losing money is something all investors seek to avoid, and apart from the financial and emotional impact, it causes further distress to investors to think that their hard-earned money may have been better invested elsewhere.

Researchers discovered that investors generally dislike losses twice as much as they enjoy making gains of the same amount. In other words, a loss of R1000 typically hurts twice as much as the pleasure of making a gain of R1000. Anecdotally, this sounds believable. Perhaps part of the explanation lies in the mathematical truth that a loss of, say, 30% should subsequently be made up for by a gain of 43%, just to get back to where the investor started – and bigger losses require exponentially bigger gains to recover.

The chart below depicts this phenomenon in more detail:

Source: Nedgroup Investments

The horizontal axis shows a hypothetical initial loss suffered by the investor while the vertical axis displays the corresponding gain needed to recover from that loss. As can be seen, in the case of greater losses, an even bigger gain is subsequently needed to recover. This may lead investors to feel that avoiding losses altogether will automatically mean that they can achieve better long-term returns on their investments.

Unfortunately, the emotional response from this loss aversion bias tends to result in many sub-optimal actions being taken. One of the biggest mistakes that an investor can make is to have a knee jerk reaction and move their investments into cash after making a significant loss, without properly understanding why the loss occurred and whether the loss will result in permanent capital impairment. Reactively moving into cash during periods of volatility also means that their expectations of potential risk and return scenarios over various timeframes were not properly informed from the beginning. Further to this, other mistakes can include trying to time the markets or making an investment that is not suitable for long-term investment goals. It is important that investors understand their true risk profiles, tolerance for losses, and long-term needs in order to make the most appropriate investment decisions.

There is existing research showing that the largest determinant of long-term returns can usually be attributed to an investor’s portfolio asset allocation. In the absence of perfect foresight to shift asset allocation at exactly the right time to avoid any capital losses, the reality is that holding asset classes such as equity, property and bonds (local and offshore) can result in greater portfolio volatility and downside risk, as opposed to being fully invested in cash. However, short-term volatility is something that investors need to withstand in the pursuit of good long-term returns.

Given all of the above, we have designed the Nedgroup Investments Stable Fund to produce inflation beating returns, while placing great emphasis on avoiding capital losses over rolling 12-month periods. These twin objectives are front of mind when making all stock selection and asset allocation decisions. At times when market risk is elevated, the Stable Fund may be more conservatively positioned, possibly lagging its peer group, but importantly, avoiding losses that erode long-term performance. 

Looking at the rolling 1-year returns of the Stable Fund vs its peers, and since inception, the historical capital protection ability of the fund is evident:

Source: Nedgroup Investments, Morningstar, data from 1 November 2007 to 29 February 2024

The grey shaded area in the chart above represents the maximum and minimum returns of funds in the peer group, the green line represents the returns of the Stable Fund, and the red dotted line reflects the point at which investors suffer capital losses. As can be seen, the Stable Fund has been able to avoid capital losses over all rolling 12-month periods (shown by the green line never dipping below the red line), which is different from some of its peers in the category.

Investing in the Nedgroup Investments Stable Fund provides investors with actively managed exposure to appropriate asset classes that generate inflation-beating returns over the long-term, while also minimising downside risks during difficult market conditions. This means that investors can rest assured that the fund managers will be more conservatively positioned during times when the risk of potential capital loss is too high. We have generally found that fund managers whose philosophy speaks directly to this concept tend to be the best performers over the long-term, as evidenced by the Stable Fund’s exceptional performance against peers since inception.