Long-term investors need shares in their portfolios
RANDS AND SENSE:
BY KHWEZI JACKSON
You will hear people talking about “safe” investments versus “risky” ones as if it were a binary choice. It is not quite that simple.
Investment risk depends very much on your investment time horizon: for short-term investors (typically less than five years), the risk lies in volatile returns and losing some of their money just before they need it; for long-term investors, the risk lies in earning too low a return and missing their financial goal.
A “safe” or low-risk investment is generally an investment that provides an almost guaranteed return with close to no risk that you lose any of your capital (because you make a poor investment, or someone steals your money). Low-risk investments (which usually include government bonds) deliver low returns, typically no more than 1% or 2% a year above inflation over the long term.
Putting your money in the bank is widely considered low risk, because you are almost certain to receive back the capital you put in, as well as interest at the rate you were promised.
The share market, on the other hand, is usually considered high risk. The return is not guaranteed and prices fluctuate, often daily.
In its best year, the South African stock market would have doubled your money; in its worst year, you would have lost half of what you put in. To compensate for this uncertainty, the share markets promise a higher return, but measured only over the long term.
Historically, this return has been about 6% to 7% a year after inflation. The worst 35-year return from South African stocks since 1900 is 5% a year (after adjusting for inflation). Future returns are never guaranteed, though, and this number could be lower in the future, but it will probably be considerably higher than the return on cash and bonds. This makes shares a low-risk investment for long-term investors.
Long-term investors should weight their investments heavily in favour of shares, accepting that the returns may be volatile in the short term but will most likely be considerably higher than that from cash or bonds over the long term.
Another important concept in the context of “safety” is diversification. Investing in only a few shares is very risky. Rather invest in a broad basket of shares that offer exposure to different industries, currencies and geographies to protect against one share’s bad performance decimating your nest egg.
Allocating a portion to other asset classes, such as cash and bonds, will protect your portfolio from being hammered by market developments. For example, when interest rates fall, interest income is lower, but it is usually positive for the share market. Alternatively, when the share market falls, bond prices tend to rise, and cash holds its value.
The ideal is to hold a diversified portfolio of assets with a market risk profile that is appropriate for your time horizon (and your tolerance for volatility). If this sounds too complicated, the good news is that balanced multi-asset funds meet all these criteria. Even better, index-tracking (or passive) funds allow investors to buy a slice of the entire market, and usually charge far less than actively managed funds while delivering similar and often superior returns.
That brings me to another big risk factor, possibly the biggest one: cost.
Over a 40-year period, just an extra 1% in fees can reduce your final outcome by 30%. A lump-sum investment of R10 000 earning 10% a year for 40 years will grow to R453 000, but to only R314 000 at 9% a year. Paying higher fees does not promise a higher net return; far more likely, it will result in a lower return.
It is important to remember that time drives risk. Before you select an investment, decide how long you would like to stay invested. This will help you to decide what type of portfolio you should be investing in and achieve the appropriate returns for the term invested. To really bust those returns, ensure that you are paying low fees, ideally less than 1% a year in total.
Playing it safe might not be as simple as you thought, but paying low fees is the easiest thing in the world. Start with knowing your fees.
Khwezi Jackson is an investment consultant at 10X Investments.