You can enhance your potential returns in the long run by investing across different investment types, says Alan Lauder, managing director of the South African operations of leading international multi-manager SEI Investments. Lauder spoke on the subject of Investing Right for Retirement at the Personal Finance/Old Mutual Retire Right seminars held recently around the country.
Investing right to retire right requires that you follow four simple steps, Alan Lauder, of SEI Investments, says. They are:
- Use your financial adviser to determine how much money you will need in retirement; the time you need to reach your financial targets; and your investment risk tolerance;
- Identify your investment style - cautious, moderate or more aggressive;
- Periodically review your status, such as your age, salary and marital status, to determine if changes are needed to your retirement plans; and
- Monitor your progress.
In following the four steps there are a number of issues to take into account, including:
Inflation
Inflation affects your savings and your spending power and reduces the value of your investment over time. The true increase in your savings is the returns you receive on your investment less inflation. For example, if your savings grow at seven percent a year and inflation is four percent, then you only gain three percent for the year.
Understand investment language
In making investments to match your investment profile you need to understand the different investment asset classes. These divide into three classes, which are:
- Cash/money markets:
These are very short-term investments, normally less than 12 months. The investments are in bank deposits or government instruments such as treasury bills where the government borrows your money for the short term. These investments provide a secure investment with little risk, but they also provide the lowest potential returns and are slow growing over the longer term;
- Bonds or fixed interest investments:
These are longer term loans you make to a company, government or parastatal, such as Telkom. The issuer (the institution borrowing your money) of the bond agrees to repay you, the investor, the original investment plus regular interest payments, during the time the bond is held. Bonds can be issued for periods up to 30 years, but can be bought and sold on the secondary market. Bonds are considered to have a moderate amount of risk; and
- Stock or equity markets:
When you buy shares, you get ownership in a company and become a shareholder. Your returns are in the form of dividends (a share of the profits) or in capital gains (from the improvement in the share price). There is greater potential for longer term growth from the share market than from other asset classes. But there is also greater potential for fluctuations in the value of your investment.
Stocks are riskier than bonds and cash, but history shows that, after inflation, investments in shares have been best. Over the past 30 years the average annual inflation rate has been 11.4 percent. After 30 years (without including the effect of inflation), you would have received an average annual return of 19.36 percent from the South African stock market; a 12.9 percent average annual return on South African bonds; and an 11.87 percent average annual return from cash investments.
After deducting the 11.4 percent annual average inflation, you would have received an average annual return of 7.96 percent from the South African stock market; a 0.79 percent average annual return on South African bonds; and a 0.47 percent average annual return from cash investments.
Choice of share investment method
There are various methods used by investors to select the correct investment. These include:
- Market timing,
where you attempt to predict when the market will or will not perform. This can be highly risky as missing only a few good days can substantially reduce your returns.
Research done in the United States shows if you remained invested throughout the 1 275 trading days between 1989 and 1994 you would have received an annual average return of 10.3 percent.
If you had missed the 10 best days, you would have reduced your returns to an annual average of 4.28 percent; and if you had missed the 40 best days, you would have lost an annual average of -6.56 percent;
- Stock or unit trust picking:
It is just as difficult to predict which share or unit trust will be the next best performer. Fifty percent of unit trust funds that were ranked among the top quarter in the US for the period 1990 to 1994 were in the bottom half of the performance tables in the next five-year period, while of those in the bottom quarter in the 1990 to 1994 period, 44 percent went to the top half in the next five years; and
- Asset allocation:
The main driver for improved performance is proper diversification over and within asset classes. Research shows that 91.5 percent of good performance comes from making the correct long term asset allocation. Only 1.8 percent comes from market timing, 4.6 percent from stock or unit trust selection and 2.1 percent for other reasons.
Asset allocation is the combination of all three asset classes, both locally and offshore. The better your diversification, the more you can lower your risk while potentially increasing your returns.
Equity investment style
There are various investment styles in the selection of shares. The main ones are:
- Size of company:
You can choose a combination of large through to small companies. Large companies are also known aslarge cap or large capitalisation stocks;
- Value stocks:
These are shares of companies which year after year provide solid profits. An example of a local large cap value stock is ABSA, or offshore, the petroleum company, Exxon. An example of a local small cap value stock is construction company Group 5, or internationally, the brewing company, Coors; and
- Growth stocks:
These are shares of companies that are growing quickly and are expected to show large profits in the future. An example of a large cap growth stock in South Africa is the information technology company Didata, or internationally, the information technology (IT) company, Micro-soft. An example of a small cap growth stock in South Africa is the IT company, Prism.
At different stages different styles will out-perform. This again emphasises the need for diversification, both across asset classes and across different segments of an asset class.
Global diversification
By increasing your international investments you can get better returns while reducing investment risk. One of your objectives in retirement planning should be the reduction of risk to your savings. It is internationally accepted that your retirement savings should be at least 15 percent offshore.
Over 10 years to December 31 2000, you would have received a total return of 206.14 percent if you had investments replicating the JSE Securities Exchange All Share index, whereas your returns would have been 860.01 percent if you had investments replicating the Morgan Stanley composite world index.
Successful investing requires that you diversify according to your risk profile. If you are extremely cautious, you should be mainly in cash and bonds; if you have a moderate risk profile, you should be invested across cash, bonds and stocks; and if you are more aggressive, you should be invested in stocks and bonds.
Investment truths
Alan Lauder says there are five basic truths to investment. These are:
- Since 1940, there have only been two years without inflation;
- Investment portfolios cannot grow over time without short-term risk;
- The two most important prices are the price at which you buy and the price at which you sell. Everything else is a distraction;
- Investing has at least a five-year horizon; anything less is either saving or gambling; and
- Past performance is a poor indicator of future performance.