Basic lessons in successful investing for the long term

Unhappy with the performance of your investments, or unsure of how to save for your retirement? A recent report by a boutique asset manager in the Old Mutual stable offers sage advice. Personal Finance reports

Most South African investors shy away from equity (share) investments, because they fear losing money. But equities have proved to be the asset class that beats inflation – investors’ “number-one enemy” – by the biggest margin in the long run. The best way to overcome the risk of losing money in equities is to stay invested for at least five years. This is one of the lessons of the latest Long-term Perspectives report by Old Mutual Investment Group’s ( OMIG’s) MacroSolutions boutique, which specialises in multiasset investments.

If, between January 1960 and December 2015, you invested in the FTSE/JSE All Share Index (Alsi) for one month, there was a 37-percent chance of losing money, according to data compiled by MacroSolutions. This probability fell to 30 percent if you invested for three months, to 20 percent if you invested for a year, and to six percent if your investment stretched over three years.

But you wouldn’t have had a negative return if you invested for five or 10 years (see graph “Probability of negative returns over different time periods”, below).

According to Graham Tucker, the manager of the Old Mutual Balanced Fund and the editor of the report, inflation is your biggest enemy, because it erodes your spending power. “At an inflation rate of six percent a year, today’s R10 000 will buy you goods to the value of only R5 584 (at today’s prices) in 10 years and R3 118 in 20 years,” he says.

Remember that the inflation rate, as measured by the Consumer Price Index (CPI), is the average inflation rate of a fixed basket of goods and services relevant to a typical consumer. Your personal inflation rate will be different, depending on the mix of goods and services relevant to you. For example, private healthcare inflation has averaged 10.3 percent a year since 1990, while the annual inflation for private education is nine percent a year, the report says.

To put into perspective how inflation erodes the value of your money, the report says a Spur burger that cost 30 cents in the 1970s costs R62.90 today, and a 750g tin of Ricoffy that cost 25 cents in the 1970s now costs R75.

Inflation is a particular problem once you retire. For example, if you retired today on an income of R10 000 a month and inflation is six percent a year, after 30 years your income will be worth only R1 741 in buying power; if inflation climbs to nine percent throughout the 30 years, it will be worth R754 in buying power. Allowing for inflationary increases is therefore critical to maintaining your standard of living on a pension.

These sobering figures underline how important it is for you to know what the after-inflation (real) return on an investment will be. You also need to find out how much of your return will be lost to fees and tax.

Cash is a poor long-term investment vehicle producing an average annual real (after-inflation) return of just 0.8 percent since 1925. Over the past five years, cash returns have been even lower than the long-term average, at 0.2-percent real returns. And it is worth noting that the 0.8-percent average return masks the long periods when cash produced negative real returns – for 23 years from 1932 and for 16 years from 1972. In 2015, the nominal (before-inflation) return from cash was 6.45 percent, whereas the inflation rate was 5.2 percent. This represents a real return of 1.25 percent.

Long- term data compiled by OMIG’s MacroSolutions shows that, based on the historical average return, you will take 92 years to double the real value of a cash investment. You will have to hold an investment in bonds for 44 years for its value to double in real terms. But an equity investment needs only nine years, on average. “It is better to own shares in the bank than to leave your money there,” the report says.

Tucker says cash is a poor longterm investment because you can’t expect a high return for lending money to a bank for little risk over the short term. “It is not optimal to grow long-term savings by making shortterm investments. Instead, you need to be rewarded for taking on risk, which is not something you can expect from cash,” he says.

Cash does have a role to play when other asset classes are falling – it preserves an investment’s nominal value and allows you to buy other assets when their prices are low. Taking each year’s asset-class performance since 1929 (86 years), cash was the best-performing asset class in only 11 of them – and in every year that the JSE was down – compared with 41 years in the case of equities (see pie chart, above).

Equities have produced an average real return of 7.9 percent a year since 1925. However, in nearly one in every three years, investors have lost money in real terms – as happened last year, when the real return was minus 0.1 percent.

Periods of poor performance create opportunities for investors to reap the benefits of buying shares cheaply. For example, the JSE lost 30 percent of its value in 2008, but then rebounded to deliver an average return of 14 percent a year over the next five years.

DIVERSIFY TO REDUCE RISK

The way to reduce the impact of poor performance by one asset class on your overall portfolio is to diversify your investment across the different asset classes of cash, equities, bonds and property.

Asset classes have distinct periods of long-term out- and under-performance. For example, bonds produced a negative real return for 40 years, before delivering great returns for the past 30 years; investors in listed property lost money between 1983 and 1998, but the sector has been the best-performing asset class since 2002. You need to allocate actively to the different asset classes to beat inflation consistently (see pie chart above).

Proper diversification means that some of your money should be in offshore assets. The exchange rate has a significant impact on investors, because it affects offshore returns when they are converted into rands. Over the five years to the end of December 2015, the Alsi returned 13 percent a year, whereas the MSCI All Country World Index returned 26.4 percent a year (in rands). The main reason for the difference is the depreciation in the rand.

A final lesson to take to heart is that money needs time to benefit fully from the power of compounded growth, Tucker says. “Compounding means making money on your original investment, as well as the gains made in previous years (growth on growth over time). The sooner you start to save, and the longer you hold your investments, the more compounding will work for you.”

The charts demonstrate the benefits of being patient when you invest in equities. The “time funnel” shows the range of real returns investors would have earned annually over different periods. The funnel narrows from the top and the bottom as the investment period increases, showing that time in the market softens the impact of periods of negative performance.