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How to make compound interest work for you

Readers’ questions answered.

CAPE TOWN – In this advice column, Mikayla Collins from NFB Private Wealth Management answers questions from two readers who want to know where to invest their money to the best effect.

Q: Einstein said compound interest is the strongest force on earth. I want to impress this on my kids so that they will start to save early in their lives. My question is: what investment options are available to maximize Einstein’s statement by saving between R200 and R500 per month?

Over the short term, banks offer various accounts for this purpose. Most people make use of a notice account where you can add to the account at any time, but when you wish to withdraw from the account you must give them notice of typically seven to 32 days.

The advantages of using bank savings accounts are that you will never lose any capital and most of the time you will not have to pay any fees. However the big disadvantage is that the interest you receive will probably be less than inflation, which means that the future value of your money in real terms or in terms of its buying power will actually be less than what you put in.

The most important conclusion when you consider the power of compounding is that a small difference in annual returns can make a huge difference to your investment over a long term. So you should try to maximise your returns with investments that offer more than bank interest rates. Two popular options available for this monthly amount are unit trust funds and exchange-traded funds (ETFs).

In a unit trust fund, the money of many different investors is pooled and invested according to the mandate of that particular fund. The returns on the underlying assets are then distributed to unit trust holders proportionately, net of fund manager fees. When you invest you need to choose funds that comply with your investment objectives and the level of risk you feel is acceptable.

There are a large number of unit trusts available in South Africa, varying from very low risk to very high risk. Capital is not guaranteed in these funds and, in addition, different funds attract different fees.

That being said, there wouldn’t be a place for unit trust investments if they didn’t produce net returns that beat bank deposits. There are some very stable unit trust funds available where the risk is minimal, and there are very aggressive funds where risk is high.

The long term returns you receive should always be higher on average for the higher risk funds. If you properly understand the risk involved and invest appropriately, then you will be rewarded.

The big advantage is that unit trust funds offer investors access to the returns of a portfolio worth billions of rand, while they are only investing small monthly amounts. Most funds have a minimum of R500 a month so if you are investing less than that your choices will be more limited, but there are still a number that will accept R300 per month, R100 per month or even R50 per month.

An additional option that has recently become popular is passive investments like ETFs and tracker funds. ETFs trade on stock exchanges like shares, while tracker (or index) funds are bought through a fund manager like unit trusts.

These funds will attempt to track the performance of an index as closely as possible, in most cases by holding the same assets in the same proportions as the index being tracked.

At R500 a month, you could never aim to hold all the shares listed on the JSE for example. But you could buy into an ETF that aims to replicate the performance of the JSE All Share Index.

Another advantage of this type of investment is that fees are typically lower than actively managed unit trusts. However, the reason for lower fees is that it is passively managed, which means that fund managers only track the index and aim to replicate its performance rather than outperform it. These funds also suffer from different levels of tracking error, meaning that they do not perform exactly in line with the index due to the timing in which trades are made.

Both unit trusts and ETF’s or tracker funds follow the same concept of allowing you access to the returns of a larger portfolio while only requiring you to invest a small monthly amount and will effectively illustrate the power of compound interest.

Q: I would like to contribute between R500 and R750 a month to an investment scheme for five years. Can you advise me which investment vehicle will be best for this goal? I will need the money to off-set some of the debt I might have in future.

A five year investment term is typically considered medium to long term and at R500 to R750 a month you could also consider unit trust funds or tracker funds as explained above. You would need to determine what kind of risk you are willing to take and align this with your expectation of returns.

Being longer term, you could afford to take some risk such as through a pure equity fund or a high equity “balanced” type of portfolio that offers some exposure to the market, but also has lower risk assets in the overall portfolio composition. This is because shorter term fluctuations will have less of an effect and you should earn a higher return on average.

You could also switch to a more conservative underlying investment toward the end of the five years, so that you can avoid the risk of a negative short term impact on your money at the time when you need to withdraw from it. Investing monthly amounts rather than just one lump sum also reduces your risk as you average out the ups and downs of the market to some extent. However, the risk you take depends absolutely on your own preferences and objectives.

Most importantly, simply identifying which type of investment you are going to use isn’t enough to ensure good returns. There are hundreds of unit trust funds and ETF and tracker funds available and it is impossible to consider them all. This is why you should not discount the value of receiving qualified and independent advice from a professional.

Mikayla Collins is a private wealth manager with NFB Private Wealth Management.

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