You need to grow your capital and earn an income

You need to invest in equities if you want your capital to grow over the long term. However, you should also diversify into other asset classes to provide a cushion against the highly volatile nature of equity investments, Jason Garner says. Garner, who m

You should not choose investments aimed at delivering capital growth over those that provide an income, because it is better to have investments in your portfolio that do a bit of both, Jason Garner says.

Investing in equities that aim to grow your capital when share prices move higher may give you a better return over the long term than income- producing investments, such as cash, Garner says.

For example, R1 million invested in the shares that make up the FTSE/ JSE All Share Index (Alsi) in October 2003 was worth R6.57 million on June 1 this year – more than six times what you invested. Although about 30 percent of this return was a result of the income, in the form of dividends, that equities pay, most of the return came from capital growth, Garner says.

However, an investment in equities is likely to be volatile, with the market rising and falling over the period for which you are invested. Depending on when you disinvest, this could result in your suffering a capital loss, he says.

If you had invested the R1 million in October 2003 and disinvested in 2008, you could have lost 40 percent of your capital value.

Over longer periods, investments that are intended to deliver capital growth typically do show gains, but it can be a rough ride, he says.

Investments in cash, which deliver returns by earning interest income, will give you a smoother ride but a lower long-term return, Garner says. One million rand invested in cash in October 2003 was worth R2.06 million in June this year, he says. This is roughly double what you started with over 10 years ago. However, after tax, this investment may not beat inflation.

Taking the risk of investing in a more volatile investment definitely gives you a better return, Garner says. This is a risk you need to take if you want your retirement capital to last throughout your retirement, because the number of years that people spend in retirement is, on average, increasing (see “Prepare for a longer retirement”, right).

Rather than exposing yourself entirely to the risks of the equity market, you should make use of the benefits of asset allocation: invest across asset classes so that you are exposed to equities that produce long-term growth, but your risk is reduced by the diversity of the asset classes to which you are exposed. In this way, you can ensure that you get higher returns, but at a much lower risk than if you invested only in assets aimed at delivering capital growth, Garner says.

Over the 10-plus years from October 2003 to June 2013, if you had invested in the shares represented by the Alsi, your portfolio would have shown the biggest losses in 2008/9, when your capital would have been down 42 percent on what you had invested, Garner says.

Had you invested in a diversified portfolio with a domestic asset mix of 62.5 percent in equities, 10 percent in fixed income and 7.5 percent in listed property, and with an international asset mix of 12.5 percent in equities, 2.5 percent in fixed income and five percent in listed property, the maximum the portfolio would have been down during the 10-year period would have been 24 percent in 2008, he says.

And if your domestic asset mix had been 50 percent in equities, 12.5 percent in fixed income, 10 percent in inflation-linked bonds and 7.5 percent in listed property, and your foreign asset mix had been 10 percent in equities, five percent in fixed income and five percent in listed property, the highest market fall would have been 15 percent.

A diversified portfolio will narrow the gap between the highest and the lowest returns over different periods (see graph, above) without detracting substantially from the average return you would have earned if you had invested only in equities over a longer term, particularly if the diversified portfolio had a higher exposure to the likes of equities and property.

Garner says when it comes to risk, you need to understand that:

◆ You usually want to take as little risk as possible;

◆ Your capacity for risk is the risk you can bear to take without getting cold feet and disinvesting, possibly at the wrong time;

◆ Your risk requirement is the risk you need to take to meet your goals; and

◆ There are two main types of emotional risk:

❑ Greed, which motivates you to enter the markets when they are at or near their peaks, and therefore expensive; and

❑ Fear, which keeps you out of the markets when they are falling or at their lowest levels, and therefore offering good value.

Garner says that a financial planner should help you to identify the risk you need to take and to align it with your capacity for risk – the risk with which you are comfortable. Then you can choose an asset allocation that matches your needs and your appetite for risk.

In investing, the real enemies are inflation and, if you are drawing from your investment, your spending, Garner says.

If your investment is not beating inflation, you are saving yourself poorer, he says.

Your required return has to equal inflation plus what you are withdrawing from your investment or spending. If you cannot meet that return consistently, you need to spend less.

For example, if in retirement you need to beat inflation and draw down eight percent of your capital each year, you will need a return of inflation plus eight percent. At the current inflation rate of six percent, your required return is 14 percent. In this case, investing across the asset classes will definitely be better than investing only in cash, which is currently delivering a return of five percent before tax, Garner says.

However, if you can expect a diversified portfolio to achieve a return of, for example, 12 percent a year, the additional two percentage points you require will eat into your capital each year, and eventually your capital will be depleted – possibly before the end of your life.

A financial planner can help you to identify this problem and can advise you how to adjust your spending accordingly, Garner says.

Investing R1 million in equities, as represented by the FTSE/JSE All Share Index, would have given you the best returns over the past 10 years, but you would have had to ride out big ups and downs in the market. Investing in an asset allocation...

Investing for longer periods of time reduces the range of returns you will earn from equities. Investing across asset classes gives you an even lower range of returns without compromising too much on the return over time.