Share this
Twitter
Digg
Del.icio.us
Yahoo
Technorati
Googlize this
Facebook
Hear this text
Print
E-mail
Tags
Investing for the long termThe income-producing capability and spending needs of families go through significant changes over the various cycles of a lifetime. One needs to instil a culture of investing from the first pay cheque until the last, and appreciate that the risk tolerance of investors will change over their investment life cycle.
Looking at the chart overleaf (the vertical axis represents spending and the horizontal axis represents time), there are at least six distinct ‘stages’ through which an average family will pass. Consequently, the family’s investment needs will require
appropriate adjusting over the full life cycle.
At the “Single” starting point (Stage 1), the early job seeker is looking to secure his/her first job. The income-producing ability is low and spending is contained.
Moving on to “Young Married” (Stage 2), income generation grows, as does responsibility and spending patterns.
By the time the family has moved into “Family, College and Kids” (Stage 4), the parents are at their peak income and spending capability.
Thereafter, as “Empty Nesters” (Stage 5), income-producing remains strong until retirement, but spending declines significantly.
Finally, in “Retired” (Stage 6), there is little to no income production and all income is produced by retirement assets on which we all seek to live out our retirement in comfort and dignity.
One observation could be to ignore retirement saving studiously until beyond Stage 4, relying solely on the high income-low spending years in Stage 5 described above. The writer would argue that such an approach places too much reliance on the “average family” income and spending habits.
The reality is that one does not know what fortunes or misfortunes will befall you over the 20-odd years it will take between Stage 1 and Stage 5, and to rely on the last 10 years of income generation to prepare you for retirement is a significant gamble which should be discouraged at all costs.
Another significant reason for saving early is to rely on the power of positive compounding of returns. These are returns that are earned on reinvested growth (growth on growth). The earlier and longer one saves, the more significant benefit one enjoys from compounding of positive returns.
Investing, like any discipline, is learnt over time. Therefore, notwithstanding low income potential and high spending throughout Stages 1 to 4, every individual should look to save for retirement.
This approach has a number of benefits:
• For even the most disciplined investor, money “burns a hole in your pocket”. Therefore a deliberate monthly allocation of your salary to retirement saving is a discipline every person should instil from their first pay cheque until their last.
• The conventional wisdom is that at least 20% of your post tax income should be saved. This includes all forms of income such as bonuses, and should not be restricted to salary only. In that 20% number, it is fair to include your spending on your house if you own one.
• There is little doubt that we are living longer and therefore our retirement needs will look dramatically different to those of our parents. It is thus crucial that we start saving earlier and save for as long as we possibly can. Also, on retirement, every effort should be made to live within one’s means, given the size of your retirement funding.
• Investing early captures one of the strongest aspects of investing: the power of compounding (where the value of an investment increases over time because growth or interest earned is reinvested – this results in growth on growth). If one starts investing early and continues to invest during the entire working career, the impact of positive compounding on one’s retirement savings is staggering. Leaving retirement savings until later in life significantly reduces the positive compounding benefit an investor would have had.
Assuming one accepts the above advice, the next question to address is what one invests into.
At the two extremes, it is fairly easy to see that an investor in Stage 1 can afford to invest with much less concern about the volatility (risk) of the investment. By the time that investor has reached Stage 6, the focus will shift quite strongly toward capital preservation or low volatility investments.
However, given that average life expectancy is around 83 years, it would not be wise to invest all one’s retirement savings into cash upon retirement.
In order to address these complexities, one should ideally look to move gradually from more risky but higher potential return investments (high weighting to equity), to lower risk and lower return (low weighting to equity) investments.
Another rule of thumb is subtracting 100 from your age (100 – Your Age) as a determinant of equity exposure. For example, if you are 25 years old, then your equity exposure should be around 75%; if you are 60, then your equity exposure should be around 40%.
The reality for most investors is that they have neither the time nor the skill to make sound investment decisions when it comes to what to invest into equity, bonds, cash and property; and then how and when to rebalance this allocation as their investment profile changes.
Fortunately in South Africa, there are categories of prudentially managed balanced unit trusts (now called “managed flexible funds”) that are classified into low, medium and high equity.
The low equity classification restricts equity to no more than 40% weighting of the fund; the medium category equity weighting must be between 40% and 65%. The high equity sets the equity weighting between 60% and 75%.
These funds also are compliant with retirement fund investment requirements, meaning that they can be used within retirement funds.
As an alternative to managed flexible funds, most unit trust companies offer inflation plus 3%, 5% and 7% funds.
While these funds seek to target inflation, they will generally follow a similar risk profile (and therefore equity weightings) as the low, medium and high managed flexible funds.
The major benefit of either of these two classes of unit trusts is that the funds are multi-asset unit trusts. The fund manager is charged with achieving the fund target return while being mindful of the economic cycle at all times. They are constantly re-weighting the fund between the asset classes to achieve the optimal asset allocation and hence the return expectation of the investors, given the risk profile of the fund.
With either these two alternatives, an investor could look to invest at Stage 1 either into an inflation plus 7% type fund or a high equity managed flexible fund.
Throughout Stages 1 to 4, the investor can continue to invest into these funds.
By Stage 5, the investor can start to shift his/her investments into inflation plus 5% or medium equity managed flexible funds.
By the time the investor reaches Stage 6, a large portion of his/her investments should be sitting in inflation plus 3% funds or low equity managed flexible funds. Such an approach should assist investors to adapt their savings to their ability to tolerate volatility (risk) on their investments. This tolerance declines naturally from Stage 1 to Stage 6.
The last issue to address is whether one would adopt a different strategy if one had R10 000 or R100 000 or R1 million or finally R10m to invest.
The crucial assessment to make is the:
• risk tolerance of the investor;
• return expectations; and
• liquidity (access) needs of the investor on that investment amount.
For recurring amounts, you would need to be disciplined to invest consistently and regularly, for example R10 000 monthly and perhaps R100 000 annually.
Recurring investments allow you to smooth out some of the natural market volatility because you are investing regularly at various points in the market peaks and troughs.
When looking at lump-sum investments such as R1m or R10m, then it would be important to recognise that investing once off exposes you to significant market timing risk. You would therefore consider parking the lump sum in a money market unit trust and phasing the funds into your target investment over at least a six-month period. This should reduce the market timing aspect to which you would be exposed.
In conclusion, the most important aspect to consider with investing is that it is forever and one needs to instil a culture of investing from the first pay cheque until the last. This long-term discipline will ensure that the investor benefits from positive compounding of returns (reinvesting of investment returns, which results in growth on growth).
There must be an appreciation that the risk tolerance of investors will change over their investment life cycle and, consequently, investments should be sought out which match those risk tolerances.
Finally, investors need to understand that market volatility is a necessary component of investing. Therefore, investing in risk-appropriate funds is a crucial weapon which should assist the investor in preventing a knee-jerk response to negative market news.
This often causes investors to invest when the market peaks and dis-invest when the market has fallen.
Evan Jones
Managing director: Cadiz Wealth
