History may not always repeat itself, but it does teach us lessons. And there are lessons you can learn from long-term data that Old Mutual has collected about inflation, the returns and risks of the different asset classes in South Africa, and the benefits of diversification. Old Mutual's latest research is published in its recently released Long-Term Perspectives 2017.
INFLATION IS YOUR MAIN ENEMY
Many investors suffer from “inflation illusion”: they don’t notice how destructive inflation can be over time, Long-term Perspectives says.
According to the publication, South African inflation has averaged 5.6 percent a year over the past 105 years, which compares unfavourably with the average inflation rate of 4.3 percent in the United Kingdom and 3.5 percent in the United States. South Africa’s inflation rate is more aligned with that of other emerging markets, rather than developed markets, the report says.
Old Mutual expects inflation to average 5.5 percent over the next five years, but there is risk that it could go higher, because South Africa is subject to the factors that affect the prices of goods globally, which are often denominated in US dollars, and this affects the rand and consequently the price of foodstuffs and petrol.
Inflation is calculated as an average for all the consumers in the country. If your expenditure is skewed towards components in the basket of goods that comprise the Consumer Price Index that have very high rates of inflation (for instance, education and health care), you will experience a much higher personal inflation rate than the country average. In this case, you need to save more for your future expenses. You need to remember this when you budget for how much you need to save for retirement, for example.
CASH IS TRASH, EQUITIES GROW YOUR WEALTH
Investing only in cash will not help you to grow your wealth in real (after-inflation) terms over time, Long-term Perspectives shows.
Over the past 92 years, cash has delivered a real return of just 0.7 percent a year, and at this rate it will take you 90 years to double your investment.
An investment in equities that earns a real return of 7.8 percent a year will double in 10 years.
“It is better to own shares in the bank than to leave your money there,” Long-term Perspectives says.
WITH EQUITIES, TIME IS YOUR FRIEND
Many investors invest in cash because they fear they could lose money if they invest in equities, but cash delivers poor real (after-inflation) and after-tax returns.
If you can leave your investment in equities for more than three years, history shows there is very little risk of incurring a loss on your capital once you calculate your average annual returns over the entire period.
Old Mutual’s data also shows that, although the equity market’s long-term trend is up, in nearly one out of every three years investors have earned a negative real return, as was the case last year and the year before.
However, periods of poor or negative real returns are typically followed by a strong recovery. Long-term Perspectives points out that in 2008 the equity market lost 30 percent in nominal (before-inflation) terms, but in the following five years equities returned 14 percent a year.
Another key lesson history teaches us is that the price you pay for the profits a company can generate, the valuation or price-to-earnings ratio (PE) of the company, is an important determinant of the returns you can earn. The equity market swings between being cheap and expensive relative to its long-term average, and the more expensive it is when you invest, the lower the subsequent return you earn.
If history is any guide, the PE is currently in the most-expensive of five price bands in which it has traded over the past 56 years for which data is available. This suggests that you may continue to earn lean returns in the years ahead if you invest across the broader market at these prices.
Old Mutual predicts that real returns in the years ahead will be lower than the 6.9-percent real return that equities have delivered over the past five years.
INVEST ACROSS ASSET CLASSES
Old Mutual’s long-term data shows that equities were the best-performing asset class on average since 1929, but there were individual years in which equities were not the best performer – in fact, investors lost money.
In total, for 86 years from 1930, South African equities was the top-performing asset class 47 percent of the time, bonds 14 percent of the time and cash 13 percent of the time.
To balance the good returns with the bad and enjoy less volatile returns, you need to diversify across the asset classes.
The data shows that different asset classes can go through long periods of negative returns.
Over the 92 years from December 1924 to December 2016, the worst drawdown – fall from peak to trough in equities (as measured by the FTSE/JSE All Share Index) was minus 63.2 percent – a loss incurred over two-and-a-half years, Long-term Perspectives shows.
It also reveals that the longest bear market in equities lasted five years, during which time investors who bought at the peak of the market lost 55 percent of their investment. When the bear market ended, it took 15 years for those investors to break-even.
The South African bond market had 39 bad years from 1947, during which time investors lost 60.8 percent of the value of their investment in real (after-inflation) terms.
Listed property had a period of deeply negative returns between 1983 and 1998, when investors’ real returns were minus 7.8 percent.
However, by blending different asset classes, such as equities and bonds, it is possible to reduce the drawdowns, or negative periods.
A simple 50:50 mix of equities and bonds reduces drawdowns in your portfolio significantly – in such portfolio, the worst drawdown over the past 92 years was 45.2 percent, Long-term Perspectives shows.
Introducing other assets classes, such as global equities and gold, can further diversify your returns.
Long-term Perspectives reports that, over the past 90 years, global equities have delivered real returns of 5.4 percent in United States dollars and 7.2 percent in rands – a lower return than local equities.
However, global equities are a powerful source of diversification and risk reduction, Old Mutual says. Global equities’ top position among the assets classes on average returns for the past five years is proof of this. Global equities returned on average 23.4 percent a year relative to South African equities’ 13 percent a year, the report shows.
In order to help you to realise the benefits of diversifying across asset classes, Old Mutual has constructed an asset allocation index, the MacroSolutions Balanced Index. This index is made up of:
• 45 percent South African equities;
• 20 percent global equities;
• 20 percent South African bonds;
• 5 percent global bonds;
• 7.5 percent South African cash; and
• 2.5 percent gold.
This index has, over the 87 years since 1929, earned a real return of 5.7 percent a year.
One rand invested in 1929 and earning the same return as the inflation rate would have grown to R191 at the end of 2016, but R1 invested in the MacroSolutions Balanced Index would have grown to R23 602 in nominal terms. This represents an increase of 123 percent in real terms, Long-term Perspectives says. An investment in local equities would have increased 472 percent in real terms and in global equities 296 percent. Cash would have increased only two percent in real terms.
“Diversification is the one free lunch in investments; use it. That is because it pays to invest across different asset classes,” Long-term Perspectives says.
COMPOUNDING IS A POWERFUL GENERATOR OF WEALTH
With equities able to deliver a return of 14 percent a year in nominal (before-inflation) terms, you can harness the power of compounding if you can leave your money invested for a long time.
Long-term Perspectives cites the example of an investment of R1 000. On a return of 14 percent a year with dividends reinvested, the investment will grow to R3 712 after 10 years. But after 20 years, it will be worth R13 780. The greatest benefits of compounding, when you earn returns on your reinvested returns, occur in the second decade.