Long-term data about South African financial markets has a few simple lessons for investors: inflation is your number-one enemy and to fight it you cannot just invest in cash. You need to invest in assets such as equities, which can deliver above-inflation or real returns. You can mitigate the risks by investing long-term and across the asset classes.
These are the lessons in the Old Mutual Investment Group’s (Omig’s) MacroSolutions boutique’s latest Long-Term Perspectives report, which was released this week. The report analyses South African financial market performance over the past 90 years.
Graham Tucker, the manager of the Old Mutual Balanced Fund, says that when you retire you will not only most likely have a lower income, but if your income does not grow by at least the inflation rate, you will experience a steady decline in its purchasing power.
The Long-Term Perspectives report says that if you have a fixed monthly income of R10 000, after 30 years at a Consumer Price Index (CPI) inflation rate of six percent, it will be worth just R1 700 a month in today’s rand value.
The inflation rate as recorded by the CPI is an average for all consumers in the country, but it may not reflect the inflation rate you experience. This is because the goods and services you consume may be subject to higher inflation than those in the CPI basket (see “Scary inflation predictions”, below).
Omig’s MacroSolutions Boutique expects inflation, currently at 4.4 percent for the year to the end of January, to average 5.5 percent a year over the next five years.
The Long-Term Perspectives report notes, however, that because South Africa is a small but open economy, there is a risk that inflation could be higher.
Tucker says that, to combat inflation, you need to focus on earning returns from your investments that are higher than the inflation rate – in other words, you need to look at real, or after-inflation, returns.
He says many people think that saving cash in the bank is a good way to save, but if you are saving for a long-term goal, such as for your retirement, or are funding an income over a long retirement, cash will not deliver a good return after inflation, he says.
Omig’s data shows that over the past 90 years, cash has delivered an average return of 6.7 percent a year, which Tucker notes is a measly 0.7-percent real return, and this would be even lower if you paid investment fees and tax on the interest earned.
Even without taking fees and taxes into account, you will need 80 years to double your investment if you invest your money in a cash deposit in a bank, he says.
Comparing cash with other asset classes, such as equities, listed property, and bonds, as well as investments in offshore markets, cash has outperformed the other asset classes only 16 percent of the time over the past 90 years, and it was the worst-performing asset class over the 10 years to the end of December 2014, Tucker adds (see table, by clicking on link below).
Cash investments in overseas markets have fared even worse, delivering negative real returns in recent years.
Long-term investors therefore need to invest in asset classes, such as equities, that can deliver better after-inflation returns. This is particularly important in a world where people are living longer – 20 or even 30 years – in retirement, the report notes.
Over the past 85 years, equities have been the best performer, delivering an average real return of 7.8 percent a year, Tucker says.
If you had invested in offshore equities, your return, as measured by a broad range of global equities, would have been, on average, 7.1 percent above the average local inflation rate.
The report notes that, in line with the rest of the world, local equities have, over the long term, outperformed cash and bonds by three to four percentage points.
Some investors are scared to invest in equities however, because, as the report notes, you can incur losses. In 2008, after the global financial crisis, the local share market, as measured by the FTSE/JSE All Share Index (Alsi), was down 23.8 percent, while in 1970 local equities fell 26.4 percent.
But there are two key ways to manage the risk of loss. The first is to remember that time is your friend when you invest in equities.
While a day trader, who aims to make a profit by buying and selling shares daily, runs the risk of losing money 45 percent of the time when investing for a single day, the investor who remains invested for a year, runs the risk of incurring a loss at a much lower 21 percent of the time.
The risk of losing money on your investment declines the longer you hold an investment. At around three years, the risk of a negative return is one in 10, and after five years the risk decreases to zero.
In addition to time in the market, you can use diversification to manage your risk. Long-term data shows the benefit of blending asset classes to minimise your risks.
The accompanying table shows that individual asset classes that are top performers one year, may in another year be ranked among the worst performers.
MacroSolutions has constructed a balanced fund index to represent a typical balanced or multi-asset fund in which you could invest.
The index currently comprises 65 percent equities, 25 percent bonds, 7.5 percent cash and 2.5 percent gold (with the allocations to each asset class represented by the index for that asset class, such as the Alsi for equities).
The return of the balanced fund index over 90 years is 12.5 percent a year, and it has comfortably beaten the average inflation rate for the period by 6.4 percentage points.
John Orford, senior portfolio manager at MacroSolutions, says that if you look at the performance of the asset classes relative to the balanced index over the years (on the table), you can see that a multi-asset investment can weather the storms of the changing fortunes of the asset classes and is a lot more stable than a single-asset investment.
While equities can be either a top performer or the worst performer, a balanced fund is likely to deliver returns close to the highest returns but smoothed out over time.
Tucker says the investment universe of multi-asset funds is growing, giving asset managers greater opportunity to diversify and hence enhance returns.
Looking ahead
The Long-Term Perspectives report notes that MacroSolutions has cut its expected real return from the Balanced Index from 4.1 percent to 3.8 percent because the prices of listed property and local equities have increased.
Looking ahead over the next five years, Tucker says you should expect a real return from local equities of between three and four percent rather than the almost eight percent you may have enjoyed until now.
The report says MacroSolutions’s concern is that the local market does not have the ability to continue to generate strong real earnings growth, as commodity prices are lower and economic growth is expected to slow.
Tucker and Orford expect global interest rates, and thus bond yields, to stay low, as global growth is still faltering, with certain exceptions, such as the United States.
In contrast, they say local bonds look reasonably attractive.
SCARY INFLATION PREDICTIONS
Medical inflation has averaged 10.7 percent a year since 1990. At this rate, kidney dialysis currently costing R150 000 a year will cost R414 000 in 10 years’ time and R1.9 million in 25 years’ time, the Long-Term Perspectives report notes.
If education costs continue to rise as they have, it means that, while it will cost R308 000 to put your child through a medical |degree at university in 10 years’ time, it will cost R1.1 million to put a child through the same degree in 25 years’ time.
THE POWER OF COMPOUNDING
You should remember the power of compounding, especially over the long-term. A rand invested on the JSE 90 years ago would today be worth R21 749, while the inflation-adjusted rand would be R162.
The Old Mutual report notes that in real terms, the R1 investment on the JSE has increased 134 times.
The report estimates that if the rand had been invested in a balanced fund, it would today be worth R26 839, as a result of diversification and a fund manager making active calls on how much of the fund to put in each asset class.