Lessons on time, type of saving, costs, risk budget, local vs overseas, the endgame, available capital vs income needed, and guarantees vs market growth
Almost all investors are, or should be, aware that risk is a word associated with returns. It comes in various guises, sizes and impacts but let’s take a minute to look at risk 101. I guess the greatest risk is not to take any at all!
My theory starts with cash and inflation. These two pedestrians are close mates. The Reserve Bank in South Africa uses, as its primary weapon, interest rates to manage the economy and inflationary ‘risk’. What this means is that if inflation trends upwards, the economy is probably heading towards an ‘overheated’ state. To avoid inflation, which is a natural consequence of an economy where there is more money than goods, the Reserve Bank increases rates to make spending, and particularly borrowing, less attractive, thereby containing inflation. The opposite is also true. So if you graph these two factors you will see a close correlation.
An added problem with earning interest is tax. The more you earn the higher your tax rate, until eventually you pay away more than 40% of your interest. This whilst you are saving and typically for longish periods of time. The point is that if interest rates and inflation are similar, tax will bedevil any chance of you making after inflation returns on your savings! This net of inflation return we will call the Real Return.
So, what must we then consider and much more importantly DO to avoid this trap?
A few factors which typically need consideration include:
- Type of saving
- Risk budget
- Local vs Overseas
- Your endgame
- Available capital vs Income needed
- Guarantees vs Market Growth
These broadly mean the following:
Time – the longer the better. If your money is available for a few months or perhaps even a year or two, safe cash is just fine. The minute this stretches to a few years and decades, real inflation beating returns become crucial. The longer the timeframe and the more regularly you add to investments the higher your tolerance to risk should be, as this enhances the likely outcome. Another aspect is how long you will live after retirement. We seem to be lasting longer, making it even more important to ensure the savings we make grow relentlessly. Whilst perhaps sounding quite controversial, I would also recommend wealthier investors stay invested in growth assets after retirement, rather than adopting a very cautious approach favouring cash type portfolios.
Type of saving – refers to whether you are investing large sums or regular smaller amounts. The latter makes a more aggressive investment less risky. We call this rand cost averaging. Volatile units or share prices are in fact beneficial to this form of saving. You are also not “betting the farm”. The outcome, if seen over the long term, is highly likely to be attractive over cautious alternatives. Large sums require a different approach. Timing of investments is usually a mug’s game. Getting timing right is probably more luck than skill. A smart approach might be to access growth funds or shares over a period of time.
Costs – watch these but recognize they are necessary, particularly when your needs are wider than JUST investment. A great advisor will deliver experience, tax advice, product enhancement, beneficial influence on what the fund or life office want to charge, input on general issues like retirement, family and business issues, wills and estates, and more. Weigh this up in your assessment, but beware of non-disclosure. Ask for some detail. The clarity of the answer will help you decide whether the advisor you’re in front of deserves your support!
Risk Budget – this is determined by how you react to volatility and also by your wealth. If you are forced to use the majority of your capital to support your income needs, you are likely to err on the conservative. The closer to retirement you are, the more you will need to heed this unfortunate reality. If however time is your ally, we would again prompt an upscaling of risk to best accomplish greater growth and a better long term outcome.
It would also be true that if you were wealthy enough not to have income needs have too great an impact on the portfolio, more growth oriented investments would be recommended.
Local vs Overseas – This is such an interesting subject. Probably the most hotly debated issue as it represents a massive risk if not properly factored into planning. If one looks at the Rand/Dollar it seems a one-way bet. This is anything but true. Whilst the trend is set, our currency is very volatile. It is driven by sentiment, balance of payment, political behavior (or lack thereof), global demand for resources, and many more issues. In the last ten years the rand has weakened three times in wildly and scary ways, only to have resurged twice. I repeat the trend is weaker, but this is not for sissies. Cost averaging remains a good approach.
Your endgame – what you and your family need, your inheritance strategy, what you actually need vs what you want are contributors to the risks and commensurate returns needed. Planning needs a destination and staging posts along the way to reassess the state of play and incorporate any material changes to the “Plan” should form part of any long-term strategy.
Available capital vs Income needs – mentioned earlier when demands on capital to meet income needs are lower, allows for a more growth-oriented approach to be adopted. They say “Money makes Money” – this is very true! Dividend yields on quality shares average around three percent. So, if you are wealthy enough to survive on a three percent return on your portfolio, you could put all your available cash in shares! We would not recommend this but the point is worth making.
Guarantees vs Market Growth – this is clearly something not always understood. No institution we have ever dealt with gives away free guarantees. They cost! Carefully understand how these work, when they are appropriate, as well as risk of them resulting in a slow, invisible loss of buying power.
As the adage goes, the only free lunch is diversification. Guidance by a professional advisor is probably a great idea. Take care of your money and get stuck in to using this guidance. I have personally and it works! All of these points are made without specific knowledge of your unique needs. Please ensure that they are not taken as advice, rather as a guideline to be discussed with a suitably qualified and professional advisor who you trust!
Mike Estment, CEO & Private Wealth Manager at NFB Financial Services Group