In my previous article, It’s all about the income, I alluded to the capital amounts required to cover different eventualities. The challenge for investors is to embark on an investment path that will provide the best probability to achieve that goal and ensure a financially fit retirement.
When structuring an investment strategy there are many factors that come into play. On top of all is investor anxiety. Anxious investors often decide to change their investment portfolios when their investment values reduce due to severe market corrections as we experienced in 2020 due to Covid-19 and in 2008 during the Global Financial Crisis. Often their intentions are to “sit it out” until the investment environment has become more conducive to investments again. This is a dangerous strategy, one that rarely works.
As financial advisors, we spend much of our time during the initial consulting process to understand the investor’s financial personality. By understanding the investor’s attitude towards volatility (note I speak of volatility, not risk) we can proceed to structure a portfolio where the investor will experience less anxiety when their investment value reduces at some point in the future.
Within the investment space, there are no guarantees of returns unless you invest in a product that has a structured guarantee offered by a large financial institution, and even there you are not fully protected against losses under certain circumstances. The only guarantee that one can be certain of is that at some point in the future your investment value will reduce due to market volatility irrespective of how your portfolio is invested. The longer your investment horizon is, the more periods of capital reduction (also referred to as corrections) you will experience and the more exposure you have to growth assets (shares and property) the larger the corrections will be. Guaranteed.
The only caveat to my comment above is cash. Cash should never provide you with a negative return. However, cash is also the asset class that has the highest probability of losing purchasing power over time. It is the worst asset class for long-term investing if you are a taxpayer. The objective for investing as a core requirement should be to at least beat inflation after tax. Cash rarely achieves this objective. Cash as the perceived “safe haven” turns out to be the destroyer of wealth if used as a long-term investment vehicle. However, for any investment objective less than two years, cash is king.
Before I continue, I would like to define risk versus volatility because these are words that one hears regularly. We often hear people referring to the risk of an investment. The fact that an investment portfolio can reduce by more than 30% during a period of uncertainty like we experienced in March 2020 due to Covid-19, does not mean it’s risky. The risk of that investment lies in the ability or inability to recover from a correction. In most cases, the investments that experienced a reduction in value during March 2020, recovered to their full value and more by the end of 2020. This is not unique. All previous corrections including corrections during the Great Depression, the tech bubble, the Asian crisis, the GFC and any other crises you can think of recovered beyond full value. Some recoveries do however take longer than others. This drop in value and the subsequent recovery is referred to as volatility.
Risk is self-imposed. Investors who disinvest at the bottom of a correction incur a permanent loss. Those who in the past moved to cash during a correction with the intention to move “back into the market” when the investment environment has improved, have delayed the recovery time of their investment and in many cases incurred a loss as far as the opportunity cost is concerned. Either way, their long-term investment outcome would be compromised. Risk is also incurred when investors chase unrealistic returns often promised by scamsters.
Cautionary: When you are offered an investment with unrealistic guaranteed returns, proceed with extreme caution. If the guarantee is not underwritten by one of the major financial institutions, walk away. Guarantees are only as strong as the guarantor. Think logically, if the risk-free rate (cash return offered by banks) is 4%, surely products offering guarantees more than double that must incur some risk or “financial engineering”?
From the above, it can be derived that before you decide on an investment strategy, you must decide on the term and objective of the investment. The longer the term of the investment the more exposure you can take to growth assets i.e., equities (shares) and property (listed property, not residential property which should be considered as a totally different asset class).
It is also important to understand the characteristics of the different asset classes and how the volatility patterns and long-term returns could play out over time. It is also important to note that irrespective of the high level of volatility that stock markets provide, it is highly unlikely that you will experience a negative return over an investment period exceeding five years. Historical returns show that the SA market has never experienced a five-year negative return over any measured period. This is a common global trend and not SA specific.
I must however point out that long-term negative returns are possible in cases where a particular market is at extreme levels as far as cost versus perceived value is concerned. A case in point is when the US technology sector moved to extreme levels in the late ’90s and finally collapsed in 2001 and caused severe wealth destruction on a wide scale. The “tech bubble” losses took the S&P 500 almost a decade to recover to levels pre the correction. It must also be said that all the signs were there and the “greedy” who believed that there was no end to where the prices could end were burnt severely. Those who heeded the caution, not only prevented severe losses (in this case it was losses since many of those tech companies did not survive) but made handsome profits by investing wisely.
There are numerous measures to determine if and how expensive a market (stock market) is. Stock selection and asset allocation is the job of investment managers, and it is their job to limit volatility by effective diversification between different asset classes and stocks on a global basis.
Let us get down to specifics. What is the cost of conservatism?
Earlier I referred to the psyche of different investors. If your personality does not allow for any variance in investment values or volatility, that is fine. Just understand that to reach your long-term investment goal, you will have to invest more than the person who is willing and able to accept higher levels of volatility which will lead to higher returns.
I am going to illustrate this with some figures. Let us go back to the figures that I used in the It’s all about the income article. In the article, I assumed that if you are aged 35 and if you wanted to retire today with an income of R40 000 per month then you would require approximately R9.6 million capital if your investment drawdown equals 5% of the capital value. If your intended retirement age is 65, then the required capital amount increases to approximately R41.5 million that will be required in 30 years’ time if inflation is around 5% per year over the next 30 years.
Since retirement funding will make up the majority of most people’s capital base when they retire, I am going to keep it simple and compare solutions that are applicable to the retirement fund industry. Retirement portfolios are regulated by Regulation 28 where there are some restrictions placed on how the funds are allowed to be invested. In short, funds used to invest into retirement funding products i.e., pension funds, provident funds, retirement annuities and preservation funds, are broadly limited to a maximum exposure of 75% in equities, 25% in property and 30% overall offshore exposure.
Once again to keep it simple I am going to compare the long term returns of three sectors namely, cash in the form of money market, low equity funds where equity exposure is capped at 40% maximum and high equity funds where equity exposure is capped at 75% maximum. Both these sectors are restricted to 30% offshore exposure. The low and high equity funds are multi-asset funds generally referred to as Stable Funds (low equity) and Balanced Funds (high equity). I am also going to refer to pure equity funds that normally have 95%+ equity exposure as well as global pure equity funds.
I have taken the long-term average returns of the sectors as they appear in the Morningstar statistics which represents all registered unit trusts. It is important to note that the return figures quoted are the average of all the funds in each respective sector. At least half the funds within each sector provided returns above the sector average (sort of makes sense, doesn’t it?) so my projections are conservative and realistic.
The best period which is most representative of what I am trying to illustrate is the historical 15-year return period which is well represented by the amount of funds, and it includes two major corrections namely the 2008 Global Financial Crisis as well as the 2020 Covid-19 Crisis. The returns shown are the annualised returns which means the average returns earned per year over the past 15 years up to mid-August 2021.
|Sector||Annual return over past 15 years||Investment per
Month req for
R41.5 million in 30 years’ time
|Amount accumulated if R10k per month is invested for 30 years|
|Money Market||7.09%||R13 280||R31 250 000|
|Money Market||5.5%||R18 100||R22 950 000|
|Low equity||8.02%||R11 000||R37 700 000|
|High equity||8.95%||R9 100||R45 700 000|
|SA Equity||9.71%||R7 730||R53 500 000|
|Global equity||11.51%||R5 300||R79 200 000|
The above figures speak for themselves.
- Current money market rates are just above 4% per year and will remain below the 15-year average of 7.09% for some time. The above figures, therefore, project a more optimistic outcome for money market funds than what currently can realistically be expected. I included a more realistic 5.5% money market return as well for illustration purposes.
- The above is a clear indication of why it is important to take exposure to growth assets.
The above also only deals with the returns required to achieve a capital amount of R41.5 million in 30 years’ time. The problem is exacerbated if the R41.5 million remains invested more conservatively during retirement. Even if we consider the 7.09% average return as the norm (as opposed to the current 4% that we currently receive). The fact that income must increase every year means that capital depletion will start within five years if income is drawn at 5% of the capital value and increases by 5% per year.
The only way to overcome this situation is to either have much more capital available at retirement or invest slightly more aggressively. If you adopt the cash approach, then approximately R60 million will be required and income will have to be drawn at 3.5% to accomplish a similar outcome as a slightly more aggressive investment strategy where R41.5 million is required and drawdown taken at 5%.
The challenge is always to construct a portfolio that will provide sufficient sustainable long-term returns to ensure that future income requirements are met in retirement yet at the same time preserve the capital as much as possible for when the next market correction happens. There are different views on this, but one strategy is to adopt the “bucket approach” where income for three years is placed in a money market component from where income will be paid, and the balance of the portfolio is invested with higher exposure to growth assets. Profits from the growth assets are then transferred to the “income bucket” when necessary.
The bottom line is that if you are a conservative investor with low tolerance towards volatility and you have sufficient cash flow to fund higher monthly contributions then, by all means, increase your monthly contributions to counter the lower returns that you will experience. If you are however limited in the amount you can contribute towards retirement funding, then you will, unfortunately, have to move outside your comfort zone and accept more volatility knowing that it will work in your favour over time. The alternative is to lower your income expectations when you retire…
I urge you to familiarise yourself with your investment portfolio and establish what the potential long-term returns may be. These won’t be guaranteed but the underlying asset classes will provide an indication of what may be expected. This is particularly important with your retirement fund/s. Ask your financial advisor to do the calculations and establish what your current and projected net replacement value is.
You are most welcome to forward any questions to us. We are also willing to do a “snapshot” analysis for you to determine your current net replacement ratio. The net replacement ratio will provide you with an indication of (compared to your current salary) what you can expect to earn as a pension taking all your retirement values, current contributions, and other assets into consideration.