Uncertainty and volatility must not scare you

Uncertainty and volatility can seem scary… don’t let this worry you

Uncertainty and volatility can seem scaryThe devaluation of the rand. Labour disputes in the mining and agricultural sectors. Concerns about our economic future. These issues all unsettle investors. The fact that the stock market performed well in 2012 is amplifying the fear. Investors worry the market cannot continue going up for longer. Should you be worrying about uncertainty and volatility too? What should really worry you; uncertainty, volatility or inflation?

Volatility is not risk

I always get grumpy when I read marketing material from fund managers. They brag about the low volatility of their funds as if this means their funds are somehow less risky than their competitors’. It’s hogwash to equate uncertainty and volatility to risk. Especially if you are a private person who needs to make smart, long-term investment decisions. If you want to generate real capital growth, pray for uncertainty and volatility. Investments with no uncertainty and volatility are either very low risk and stand little chance of beating inflation, or these are Ponzi schemes.

Uncertainty and volatility give opportunity

Where would you rather invest your money today, in platinum miners or the listed property sector? I’m sure many people prefer listed property. The returns have been great (especially last year). There is a good chance these companies will generate income and profit in the next few years.

What about platinum? The unions seem hell-bent on destroying their source of employment in a lethal game of chicken to get higher wages for a reducing number of employees. Some platinum miners are even being publicly targeted by Government. This is never a good sign for investors. However, if forced to allocate money to only one specific sector today, I would consider platinum miners and not listed property. There is good value in these miners. They have no international competition, so they have a natural monopoly. The uncertainty and volatility facing the sector is precisely what creates the investment opportunity.

Manage uncertainty and volatility, don’t avoid it

Most international markets, including SA, have performed well recently. Uncertainty and volatility has reduced and most equity investors are in a comfort zone. This is probably a good time to start worrying. Complacency coupled with equity investment is never healthy. The chance that equity markets will generate reduced performance in the years ahead is increasing. It will be difficult for most asset classes to beat inflation over the next three to five years.

Am I saying you should sell out of equities? Definitely not. I do recommend you diversify your portfolio across a range of sectors and asset classes. No-one knows if the stock markets will continue to run for the next year or three. I prefer earning dividends and not interest on cash. Optimally diversify your assets  in volatile conditions as an effective strategy.

The best investors never invest with absolute conviction. They realise the stock market will always do the unexpected in the short-term. This means they don’t bet the house on one particular strategy. Smart investors allocate some capital to one strategy. But if they’re wrong, they will have capital allocated to other strategies too. They do not take unsustainable losses. Absolute conviction with investment is always fatal to capital growth.

Inflation is your real risk

Over long periods of time the effect of inflation on your money is your real concern. If you don’t invest in productive assets such as shares and commercial property, you are guaranteeing the value destruction of your capital. This is especially true if you invest in cash and other “low risk” assets, because you want to avoid uncertainty and volatility. This is not a good strategy for long-term investing.

Productive assets are by their very nature volatile. Ideally you should focus on the income from these assets. If the income they generate increases faster than the inflation rate, the volatile nature of the capital invested is not relevant. It’s one of the reasons why Warren Buffett avoids IT companies. He cannot predict their income in the next 10 years. Therefore he allocates his capital elsewhere.

If the markets take a beating in the next year or two, I will probably increase my allocation to shares beyond my normal targeted percentage. But I will always maintain some asset class diversification. Just in case.

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Be your own fund manager

Stock marketTrying to determine whether the JSE is expensive, what is happening to resources, where the rand is going and what further damage politicians will do to our markets is an impossible task. Many investors (and their financial advisors) choose to outsource control of their investments to fund managers of flexible or balanced funds. The belief (or hope) is that the fund manager has a better insight into the future than the rest of us. Frankly, I think these investors (and their advisors) are making a big mistake. Private individuals who control their own asset allocation in a rational and structured way will do much better in the next few years than flexible or balanced funds.

Fund managers make structural errors

Many credible fund managers (not all unit trust managers are credible) make two structural mistakes with their balanced or flexible funds over the long term. Firstly, they are usually under-invested in equities over longer periods of time and secondly, they are almost always under-invested in listed property. The usual explanation from balanced fund managers about their under-investment in shares is that they are protecting investors from potential losses if the stock market drops. A fund manager who remains conservative with equities in a balanced fund over the long term is more likely to keep his job because he won’t have a blow up in a 12 month period. This does not necessarily mean he is doing a good job for his investors.

Listed property is more interesting, it is very rare to find balanced funds with a large exposure to property companies. This is partly because the property sector is quite small in comparison to the rest of the stock market. However this is not the only reason. I have a view (not scientifically proven) that most balanced fund managers are equity managers at heart and are not fundamentally comfortable with listed property. They will take small positions at certain stages in a market cycle but for the rest of the time will avoid property. As you can see from the table below, an underinvestment in property (as shown by property unit trusts) was a very poor decision over the last five years.

Asset Class Index/Fund Name 5 year annualised returns
Shares All Share Total Return 8.14% per year
Property Average of all property unit trusts 12.21% per year
Property Best Property Unit Trust 16.18% per year
Balanced Funds Average Balanced Funds 7.14% per year
Balanced Funds Best Balanced Fund 10.08% per year

Source: Morningstar

One could also infer from the table that the average balanced fund manager was very risk averse over the last five years, in a time when interest rates were declining, which was great for local bonds and listed property.

Take control

For a private investor, there are few limitations on the portion of capital that you can allocate to any asset class. It is unlikely that a very large balanced unit trust will invest 15% or 30% of its capital in listed property because the property sector is too small. This would not be a problem for an individual and so it does not make sense to allocate the bulk of your capital to a balanced fund where you will be limited from investing in quality listed properties. Having said all that, I am not advocating that you place all your money in listed property – far from it. I feel you should create a structural asset allocation for yourself that is not determined by external factors. To start with, if you adopted a really simple approach to asset allocation, you could do the following:

Asset class Percentage Allocation
Shares 50%
Bonds 25%
Listed Property 25%
TOTAL 100%

 

The real benefit of this approach is that you determine your allocation to growth assets based on your own situation. It is only by investing in growth assets (equities and listed property) on a sustained basis, that investors will make the maximum possible return without taking excessive risk. If the stock market continues to rise, fund managers are likely to reduce their exposure to shares and listed property even further. This is because they are worried that the market might dip in the short term but a short term dip might not be relevant to you. If you bought quality growth assets at a great price, the fact that they fall for a year or two might be irrelevant if you are investing for 20 years. You might have bought the investments 8 years ago and so a 15% drop from current levels would be small in the context of your overall investment performance.

My preference would be to allocate portions of your capital directly to an equity fund, property fund and bond fund. You can then determine when to rotate asset classes based on your own goals rather than the fund manager’s.

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The perfect Portfolio?

Many South Africans love physical property as an investment. Personally, this fixation has always fascinated me as I wonder if these property investors know what they are missing by ignoring the other major investment types available to them. For example, listed property companies that trade on the JSE have been fantastic investments over the last 10 years. People who bought these companies have earned 22% per year over the last 10 years and they earned this growth without having to deal with tenants or maintenance issues. This is only one of the alternative investments available to individuals who are willing to consider alternatives to residential property.

Long term history is a good indicator

The table below shows the long term returns of all the major investment asset classes available to South African investors. The returns over 10 years are most relevant as the 2 to 5 year information is too short to be helpful although it does make for interesting reading.

10 Year Return of Major SA Asset Classes

10 Year Return of Major SA Asset Classes

It is clear from the 10 year history that listed property and shares (equities) are an ideal combination for long term capital growth. If you include bonds as a stable, inflation-beating asset, I believe you can create the ideal portfolio for any individual simply by using a stock broking account. If you are reasonably young and looking to grow your assets without an immediate requirement for income, you could combine an investment in shares with listed property. A good allocation would be 75% in shares and 25% in property.

If you are looking for a combination of capital growth and income, you could reduce your allocation to shares i.e.: 50% equities, 25% bonds and 25% in property. This combination should ensure that your capital grows more than the inflation rate whilst generating a good income. If you are not built to cope with the volatility of the stock market, you could reduce your investment in shares to 35% and increase your investment in bonds to 40% and property at 25%.

The costs of creating and maintaining any of these portfolios would be quite low (initial brokerage plus a monthly portfolio fee) especially compared to buying physical property assets. If you are considering buying residential property, you will be paying massive transaction costs and ongoing maintenance costs.

In addition, your risks in a listed property investment are significantly lower as your property portfolio consists of hundreds of offices, factories and shopping centres rather than a limited number of individual properties. You will never have to go to court to evict a non-paying tenant nor will you have to worry about inefficient municipalities etc. because your assets are managed by professional managers who get paid to do this stuff for you.

What to invest in?

The easiest (and probably most cost effective) way of creating a diverisfied portfolio for yourself, would be to invest in Exchange Traded Funds (ETF’s). ABSA offer two diversified ETF’s (called MAPPS) that you can buy via your stock broking account that will give you the necessary equity and bond exposure. You can then add your property exposure via the Proptrax ETF’s or you can buy individual property shares.

Some costs are declining

When ABSA launched the MAPPS ETF’s, I was really excited about these investments until I found out how much ABSA were charging to manage them. I am very glad to see that they have recently reduced the costs of these investments substantially; so that they are now really attractive investments. Unfortunately, I feel that Proptrax are charging too much to manage their ETF’s which makes it difficult for me to recommend these investments at this stage.

Is the market too expensive and should you wait to invest?

The JSE is on a charge at the moment and is breaching new highs on a regular basis and this is causing people to question whether the market is getting too expensive. This is one of the themes that financial journalists start repeating whenever the markets do well for an extended period of time. I agree that you need to be careful when investing your capital into this market however; your decision should always be made in context. The JSE index might be above 34,000 but the PE of the market (its real value) is near 13 which is well below its historic highs. I become very fearful when the JSE gets close to a PE of 19 but not at 13! Many fund managers are suggesting that foreign markets are trading at lower PE’s than the JSE and therefore we should rather invest offshore. I think this misses the point that the JSE itself is not in expensive territory yet. If you are investing on a monthly basis, you have no cause for concern whilst lump sum investors should probably make their purchases over a number of months to reduce the impact of volatility on their investments. There is certainly no need to avoid the JSE in the hope that it will drop in the near future, the market could continue on its path for many months yet.

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The Elements of Investing – the one book you should read this year

I cannot count the number of investment books, articles and publications that I have read since I started financial planning in 1996. In that time I have read a few great books that I believe everyone with an interest in money should read. Recently I read another great book that I wish I could send to all the people who email me on a weekly basis asking how they should invest their money – after reading this book, I think they would have most of their answers.

The elements of investing

The book is called The Elements of Investing, the authors (Malkiel & Ellis) tried to distill all the investment/financial knowledge that they have jointly accumulated over very long and successful careers in the investment or related industries. This is the book I wish I had written because I think they provide a fantastic investing blueprint that covers all the main principles we need to know about investments and saving. More importantly, their style is so simple and easy to read that the book can be given to anyone who wants to start saving and investing. If you are a really slow reader, it will probably take you one week to read the book while most people would finish it in a day.

Diversification

The authors explain that there are three aspects to Diversification: across asset classes, within asset classes and over time. Most people would be aware of diversification within specific asset classes (e.g. invest in a range of different shares and not just one share) and also across different asset classes (e.g. shares, bonds, cash and property) but; most people don’t understand the importance of diversification over time. If you want to invest in shares, especially if it is a lump sum, phase your money into the market over a period of months. For example, those who invested in the US market in the year 2000 would probably still not have recovered their losses 11 years later. However if you had invested over a 12 month period starting in June 2000, you would probably have made a healthy profit in subsequent years and you would certainly be in the money now.

This same principle applies when investing in bad times; we cannot determine when the market has bottomed so it makes sense to phase in your purchases over a period of months. You will never be exactly right in the timing of your purchases but at least you will have some capital committed before the inevitable recovery. You cannot simply “wait for things to get better” as this means you will never participate in the recovery. In 2008/9, the JSE dropped to around 18,000 and if you had waited “for things to get better” you would still be sitting in cash (because the financial system is still a mess) whilst the JSE has recovered beyond the 30,000 level.

What is risk?

Most investors perceive market volatility as risk however; it is only hazardous for traders or speculators because of the limited duration of their investment horizon. If you are a long term investor, volatility presents a great opportunity for you to buy great shares at a discount when others are panicking. To me, the impact of inflation on your assets is a far greater risk than volatility. Inflation destroys the value of your money incrementally on a daily basis so there is no major event that alerts you to the danger. Normally, you will only realise the impact of inflation once it is already too late and your capital is no longer able to sustain your lifestyle. The only safe way to beat inflation is to invest in growth assets like shares which are by their nature, volatile. People who don’t understand this concept often suffer in retirement because they avoid volatility at the expense of inflation protection.

Asset allocation

The authors also provide some guidelines for investors to determine their appropriate allocation to shares and bonds. Whilst I do not completely agree with their guidelines, because they make them age related only, I think they are worth considering if you have no other basis for determining your ideal asset allocation. In essence, most people should have a range of 35% to 75% of their investment capital in shares. If you have less than 35% in shares with the balance in cash and bonds, there is little chance that your capital will outpace inflation over the long term. More than 75% invested in shares is classified as a high risk strategy, especially if you require income from your capital.

Conclusion

The theory behind the investing business is actually quite simple and easy for anyone to implement over time. Unfortunately, a successful investing career also requires patience and discipline which is why most people do not make a success of their investment careers.

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The cheapest way to buy ETFs

I have been a staunch advocate of Exchange Traded Funds (ETF’s) from the launch of the first ETF in November 2000. Since then, many new indexed products have been launched and various companies have created new options for purchasing these investments. As a result, I have been getting an increasing number of questions from readers asking me how they should buy these indexed investments. The variety of purchasing options available to investors makes the answer quite complicated. To that end, I am very grateful to one of our regular readers, Hercules Viljoen from Pretoria for sending me his research on the cheapest way to purchase ETF’s. I wish more people would take the time to share their research so that we can all benefit and the best product providers get the most support.

Feedback from a reader

Hercules (who does not work in the investment industry) has taken the time to analyse the cheapest way for an individual to buy ETF’s. More specifically he has analysed the impact of the purchase costs for different amounts of money e.g. R500, R1,000 or R10,000. He was adamant that I remind people that this is his own research and investors should still do their homework before investing their money.

Range of options

You can currently buy ETF’s via two main platforms, either directly from an ETF promoter e.g. www.etfsa.co.za or www.satrix.co.za or via a stock broker. What makes the cost comparison complicated is that some stock brokers have different pricing structures for different investments. In addition, these costs do change regularly. One aspect of Viljoen’s research that I really like is that he has incorporated the cost of selling your investment after a 10 year period to make the comparisons realistic. This is important because it means we can see the cost of buying, holding and selling the ETF’s which is what most of us will do with these investments over time.

My understanding of Viljoen’s research shows that buying ETF’s directly from an ETF promoter is your best option for smaller amounts e.g. from R300 to R1,000 per month. The transaction costs are lowest and your holding costs are not too high in comparison to a stock broking account where they normally charge a fixed fee and not a percentage fee. If you are investing larger sums e.g. from R1,000 to R8,000 per month, a stock broking account using one of their special pricing packages might work best. Some stock brokers like Standard Bank and FNB Online offer reduced trading costs if you trade specific shares or ETF’s. These are the more tradable (liquid) shares on the JSE and are specified by these brokers on their websites. For larger transaction amounts (over R8,000) the picture becomes quite murky indeed. Typically, your best cost for large transactions (over R10,000) will probably be a normal stock broker and can be negotiated.

As Viljoen points out, the bulk of South African, middle income earners will probably be investing between R1,000 and R8,000 per month and this means the specialist trading packages from the stock brokers are the lowest cost option. This is especially true if you invest this money on a monthly basis over a long period of time because your annual holding costs will reduce as your investment grows in size. With the direct ETF promoters, your annual holding costs also reduce as your investment grows but not by the same extent as the online brokers. Viljoen personally prefers the Standard Bank option called ASI but he says FNB Sharebuilder product comes a close second. If you would like to see Viljoen’s detailed model you can find it here.

Below R300 is problematic

For the past few months I have been doing some extensive research into low cost savings options for people who can only afford amounts of R50 – R300 per month. Sadly most of the investments that accept small amounts on a monthly basis are actually quite expensive (in percentage terms) to the extent that your growth is usually eroded by costs. Sadly even the government RSA Retail Savings Bonds do not cater for monthly investments. This means your best option for smaller amounts is probably to save the money in a money market account and then to do quarterly or half-yearly payments into a higher growth savings option like an ETF. There are some interesting service providers who are investigating how they can use their existing infrastructure to offer low cost savings vehicles for smaller investors.

Conclusion

The current market conditions have been wonderful for people who are saving on a monthly basis. The dramatic volatility has offered quite a few opportunities to buy great investments at ridiculously low prices. For those of you who should be saving on a monthly basis and are not doing so now; make a start as soon as possible. There is no guarantee that the market will continue to offer such good value so you need to climb in now. Don’t worry about all the roller coaster movements that we are seeing now, this is good for savers so take advantage.

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Chattering monkeys

I have been away recently so I missed much of the recent market turmoil and the resulting press coverage. This means I did not agonise through the massive fluctuations we have seen recently. I have however, spent some time catching up on the press coverage of the turmoil, which would have been comical had it not been about such a serious topic.

Investors on a train

Whenever I experience major market events, I am always reminded of passengers on a train. All of them want to get to the same destination as quickly as possible. However, before they arrive at a particular station someone near the front of the train yells, “Fire!” Some people jump off the train although they have seen no smoke nor have they seen any other evidence of a fire. Other passengers remain on the train and start looking for real evidence of a fire.  The last group sit on the train reading their iPads and listening to music. The first group of passengers that jumped off the train are now stuck on the side-lines at the station and are “safe” but no closer to their destination. The second group are getting closer to their destination but are concerned about a possible fire. The last group are also getting closer but are living in blissful ignorance which could be catastrophic if there really is a fire.

Unfortunately almost every day represents a “station” for investors to get out of their investments and there is almost always someone in the press warning about a fire somewhere. Those who jump off every time someone yells “Fire!” will never get to their destination. The blissfully ignorant group will either arrive happy and unstressed or they will meet with a horrible accident. You should try to be more like the second group of passengers who will only get off the train when they see real evidence of a fire.

What have you done?

If you talk to the more successful money managers about the recent market turmoil, they have remarkably similar attitudes to managing money in these times. They were all worried about the markets and thought that they might drop a bit but none of them anticipated the magnitude of the drops we have seen. If you ask them what they have done since the markets dropped, most of them would say that they have done very little selling but they have been buying investments aggressively.

Personally, I believe that these major market events are great opportunities to buy investments and horrible times to sell. If history has taught us anything, the best investors are like those passengers who remain on the train and only get off when they see real evidence of the fire themselves. Similarly, they are also the first passengers who get on the very first train that comes along after a fire. This is certainly the attitude of Warren Buffett who almost never sells but is a regular buyer of shares. He gets depressed during booming markets because he cannot find anything to buy but he gets really excited during market turmoil because he finds lots to buy.

Chattering monkeys

One reality of the information age is that you are constantly inundated with “information” from “experts” all round the world. Much of this information is fed to you in 140 characters or less and most frequently via a dramatic headline designed to grab your attention. Sadly this “information” is pretty useless to someone who wants to make informed decisions about their investments. The people who feed you this stuff are like chattering monkeys in a tree who are able to overwhelm anyone with their noise. The noise can reach such a level that it prevents any rational thought and this can be disastrous for investors. In times like these, you should try really hard to tune out the chattering monkeys and focus on your own situation. You cannot control major market events and often the effects of these events are dramatic in the short term but largely meaningless in the medium term. That means you could use a major market drop as a great time to buy quality investments but you should really not sell them. That would be most similar to the passengers who jumped off the train because they listened to the chattering monkeys who had no idea what was really happening either!

In summary, I think you should not be losing sleep over your investments during this time. You should be trying to find extra money to invest in quality assets which are being sold by those who have been induced to panic by the noise.

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Dividends are king

If you are going to invest in shares in an attempt to generate long term capital growth, you need to understand how this growth can be created. There are three main components to capital growth from shares: inflation growth, share price appreciation and re-investing dividends. Most investors don’t fully appreciate the massive impact that dividends have on real capital growth. If you eliminate the impact of dividends from your share investments, you reduce your potential capital growth by as much as 60%.

Three parts to capital growth

If we analyse how investors benefit from equity investments, we see that their growth comes from three sources. The first source is the easiest to understand, shares increase in value over time with inflation. Your shares will not automatically increase in price by the inflation rate every year but revenues and profits will increase which will have an impact on share price performance. If your share portfolio has doubled in value over a five year period and inflation has averaged 6% per year then your shares have actually only grown by 9% per year in REAL terms.

The second source of capital growth is the actual share price movements that you see on a daily basis. As an example, when you buy a share at R2.00 and it moves to R4.00. If the share price rises faster than the inflation rate, you are getting real capital growth. Most investors would think that this is the only source of capital growth from shares. The biggest source of capital growth from shares actually comes from the re-investment of dividends from shares.

The graph below shows the growth you would have had if you had started investing in the JSE on 1 January 1960 and ended in April 2009. Over this time, the real growth on your capital was 7.3% per year. If you include inflation, the total growth was 15.8% per year. What is really important is to understand that dividends contributed more than 60% of the real capital growth. The graph shows that the actual price rise of a share will assist in generating real growth but you need to re-invest the dividends from the company every year to get the full benefits of share investing.

GRAPH A: FTSE/JSE All Share Index: Components of Total Nominal Return (Jan 1960 – Apr 2009)

GRAPH A: FTSE/JSE All Share Index: Components of Total Nominal Return (Jan 1960 – Apr 2009)

Source: Data from McGregor BFA, method derived from Plexus Asset Management; analysis by Cannon Asset Managers

When stock markets are going through turbulent conditions, many investors do not re-invest their dividends which erodes their potential returns over time. The re-invested dividends increase your capital base for future dividend flows. As an example, if you currently own 1000 shares at R10.00 per share and you get a dividend of 30c per share, you can then buy more shares. When the company announces its next dividend e.g. 31c per share you will now have 1030 shares (as an example) earning dividends. This might seem like a small increase but these incremental increases have a large compounded impact over time.

Dividends are such an important part of share price growth that you would be better off not investing in shares if you don’t get the dividends. The compounding effect of dividends will protect you from capital losses over time. You would actually be better off investing in Government bonds, the real growth is 2% per year and your market risk is much lower than shares.

The graph also shows the benefits of long term equity investments. If you are an equity investor and you only buy the index and re-invest your dividends, it is unlikely that you will lose money in REAL terms if you invest for periods of eight years or longer. From the graph you can see that there was only one eight year period since January 1960 where you would have lost money in real terms and that was if you invested at the market peak in the late 1960’s and sold your shares in the late 1970’s.

The graph also shows the real dangers of inflation, which I feel poses a far bigger threat to long term savings that stock market risk. Because the effects of inflation are not sudden and dramatic, we don’t really feel them over one or two year periods. Unfortunately you will only really feel the full effects of inflation once it is already too late. In summary, the graph above paints a clear argument for investing some of your money in shares over the long term – almost no other asset class provide the same inflation protection.

How to invest for dividends

There are three main ways to invest in dividend generating shares: direct share purchases, ETF’s or unit trusts. If you decide to buy high dividend yielding shares directly, look for companies that have a long track record of paying dividends. Try to understand the nature of the business so that you understand how these dividends are generated and whether they are likely to continue. More importantly, make sure the company has a dividend policy, this makes it more likely that the company will continue to pay dividends in future. Remember that property companies do not pay normal dividends, their income is earned from rent and so the full dividend is taxable.

If you decide on an Exchange Traded Fund (ETF) rather than a direct share, you could look at the Satrix Divi, ABSA eRafi Overall or Satrix Rafi. Whilst the Divi is the only one sold as a dividend investment, the Rafi’s are also structured with dividends as a major filtering criteria. For investors who want to control their own investments but do not have the required skills to make direct shares purchases, these ETF’s may be the best alternative.

The final alternative is to invest in Dividend Income unit trusts where you pay fund managers to choose individual shares that they believe are going to pay maximum income over the long term.

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Make your first million

It is simple but not easy to make R1 million from investing, all you need is: R5,000 per month, some patience and discipline.

The formula

There is no easy way to get rich quick. People who have become wealthy in a short space of time have either gambled or been extremely lucky. Your only guaranteed way to get rich is to follow a few simple (but not easy) steps and be patient for a few years.

Step 1: Get out of debt

You cannot get rich if you have short term debts such as credit cards, clothing accounts and overdrafts. If you really want to become wealthy, you need to pay off these bad types of debt as quickly as possible. Thereafter you can keep your good debts such as home loan and car debt.

Step 2: Build an emergency fund

You need to build up a cash account that is accessible at short notice. Try to keep 3-6 months worth of your monthly expenses in this account. It is not an investment and should only be used to pay for emergencies such as a car breakdown or insurance claim. The purpose of this account is to avoid the situation where you have to sell investments at the wrong time.

Step 3: Start saving

Younger people can invest all their savings in shares because they have the time to let these investments grow. In your lifetime as an investor, you are going to see many stock market crashes and recoveries, your job is to simply keep saving through all of them. Ignore all the people and pundits who will try to scare you out of saving, just keep your head down and stick to the plan. Ideally you should save as much as possible in the beginning. Try to ensure that you save a minimum of R5,000 per month. I realise that R5,000 might seem like a large amount in the beginning but you have to decide – do you want to be financially independent or do you want to work for a salary for the rest of your life? As I mentioned at the start of this article, it is simple but not easy to get rich.

Step 4: Where to invest

The ideal place to start saving is in an exchange traded fund (ETF) or indexed investment. ETF’s are low cost investments that will generate fantastic growth over the long term. If you want to start making a million rand every 2 to 4 years, you will first need some capital. As they say, “Money makes money.” By now, I am sure you are wondering how on Earth you are going to make this kind of money so quickly.

How it works
  • You need to save R5,000 every month for a period of nine years.
  • Try to invest all this money in the stock market e.g. in an ETF.
  • After nine years, you will almost certainly have a R1 million worth of investments.
  • If you keep investing R5,000 and add it to the first R1 million, you should have another R1 million within 4 years.
  • By sticking to the plan, you should have your R3m in total within 16 years.

Whilst 16 years might seem like a long time, you can reduce the period by saving more money as your salary increases over time. Any bonuses or other lump sums that you can add to the investment will speed up the process significantly. There is a real-life example below of someone who has saved R750,000 in less than four years.

Why this works

It is possible to save this kind of money because of the growth potential of the share market and the power of compound growth. Since the year 1900, the stock market has generated an average return of 7% above inflation per year, which equates to a nominal return 12.5% per year. That means you don’t need to be a rocket scientist or have any special stock market knowledge to be a successful investor – you just have to be disciplined and patient.

The real-life example

In February 2007 I met a young person who asked me to advise her on how she should start investing. She was 25 years old and had R9,000 to invest every month. We worked out a plan very similar to the one outlined above and she implemented it on her own for the next 3.5 years. In June this year, she emailed me to say that she had more than R700,000 in her share portfolio (primarily ETF’s) and was hoping to have R1m by the time she was 30, she is nearly 29 now. As her career progressed, she started earning very good money at an early stage in her career but she maintained a low-cost lifestyle. She did not buy fancy cars and she continued to rent a small apartment – this was the difficult part of the plan but she did it relatively easily. Most of us would be tempted to start spending more money as our earnings increased, she avoided this trap and is now on her way to financial independence.  She is now considering the option of starting her own business in a few years because she will have enough savings to live off. That means she won’t need a job or a boss, she will be financially independent before she is 35 years old. To me, this is the best reason to save when you are young – it gives you the freedom to make great life-changing decisions.

Conclusion

I realise that most people can’t earn the same salary as the person in my example but everyone can follow her formula. As you can see, there is no secret recipe,  you just need to save constantly and keep your lifestyle costs in check.

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Trader or long term investor

One of the great debates in the investment industry is around the benefits of long term investing vs. short term trading. In the one camp you have investors like Warren Buffett as one of the champion long termers and George Soros in the opposing camp. The track record of successful long term investors cannot be ignored, however the argument in favour of traders is far more intuitive and more easily understood by outsiders. This is especially true AFTER a market crash when people wonder how long term investors remained invested when the markets were so obviously overvalued.

Investing is a mystery not a puzzle

My current favourite author is Malcolm Gladwell who wrote “Tipping Point” and “Outliers” amongst others. In his most recent book, “What the Dog Saw” he discusses the difference between a puzzle and a mystery – a discussion that is very relevant to the investment business. He suggest that puzzles can be solved simply by gaining sufficient information to solve the puzzle. Conversely mysteries are made more difficult to solve because there is too much information, much of which is contradictory. The key to solving a mystery is determining what information to use and what information to ignore. His example of a puzzle is the Watergate scandal that was solved by two inexperienced young journalists who had the courage and persistence to gather the information needed to bring down an American president. They did not need any experience or expertise to crack the case, they simply needed to gather enough information. By contrast, investing is a classic example of a mystery because there is simply so much information available that it is impossible to absorb it all and decipher it correctly. Much of this information is contradictory so simply gathering more information will not help the situation.

Gladwell argues that mysteries are best solved by experienced experts. That means investors who are successful over time are likely to be highly experienced experts who have the necessary skills to know what information to use and what to ignore. The point of this article is to determine if there is more merit to trading or long term investing and my first comment is that we cannot use one hit wonders to prove our argument. We need to realise that success in this instance is measured over decades not months.

Trading

It is only human nature to want to make money as quickly and as easily as possible. Any investment methodology that allows you the opportunity to make returns quickly is naturally going to be more attractive at first glance. At its core, this is one of the real attractions of trading as an investment philosophy, it allows you the opportunity to make money quickly. The philosophy of a trader is more easily understood by outsiders – you can make money if you are able to buy an item cheaply and sell it to someone else at a higher price. Market crashes are almost always obvious with the benefit of hindsight. Using this hindsight one could argue that  any person with a bit of savvy should have been able to anticipate the crash. This means they could have exited the market before the crash and bought in again after the crash. I am naturally simplifying the case for trading substantially but hopefully it illustrates the point that trading is simple…in principle.

In addition, traders are able to use more complex financial instruments to profit from market crashes by selling short. There are many hundreds of ways to be a trader but there is one theme that characterizes most traders – time horizon. Traders are not making investments that will only be realized after three to five years. Their timeframes are typically shorter than 12 months. This reiterates the point that trading allows you the opportunity to make money quickly. This was clearly illustrated by George Soros who made $1.1bn in a brief period by shorting the UK currency in 1992.

One of the most interesting traders to me is the well known author Nassim Taleb who wrote “Black Swan” and “Fooled by Randomness”. Taleb’s method is one example of a trader who does not make money regularly but makes a large profit when he does. He keeps most of his money in US Government Bonds but takes small “bets” with the balance on events which are unlikely to occur i.e. they are unpredictable and rare in occurrence. He calls these events, Black Swans. Because they are unlikely to occur, financial institutions and other traders are willing to give him healthy odds on his bets. Taleb will lose small amounts of money every day but occasionally these rare events happen and Taleb makes a killing. One could say that he invests in a similar way to someone who uses 1% of his monthly salary to buy lottery tickets and saves in the rest in Government bonds. The person is probably going to lose money on every ticket but in the unlikely event that the person wins, the payout is going to be massive in relation to the price of the ticket.

My primary concern about trading is the number of investment decisions that a trader will have to make in his lifetime. Every investment decision is an opportunity to make a mistake. This is particularly true if you are under pressure to make money all the time. This pressure is compounded when you have made a few mistakes and the market is going against you. In this situation it is very difficult to remain rational in the face of the storm. This is why we most often read about big blow ups occurring in firms that specialize in trading. Even very successful traders blow up e.g. LTCM or Victor Niederhoffer who has “blown up” twice in 1997 and 2007! One does not find that many examples of honest (as opposed to criminal) long term investors who have blown up.

Long term investing

This is a less intuitive method of investing but is perhaps more simple to understand. Long term investors aim to buy an investment and to hold it for an extended period until the investment reaches a specific target price at which time it is sold. They will usually aim to hold their investments for at least three to five years. This timeframe provides investors with less opportunities to make investment decisions which is actually a good thing. It means you are less likely to be influenced by short term events that could influence you into making irrational decisions. Longer timeframes allow you to have a better perspective of events. If you only expect to sell something in the next 3 years, you are less likely to react to news which might impact a share price for a 3 month period. For a trader, three months is the equivalent to a lifetime.

I am unashamedly a fan of long term equity investing. This approach was made popular by Allan Gray in South Africa although I favour Cannon Asset Managers and Foord Asset Management. A good long term investor would treat each decision to buy a share in the same way that a person would decide to buy a home. You need to look at all the defects as well as the positive factors with a view to keeping the investment for the next 10 or 20 years. Long term investors only get really rich after 10 or 15 years of investing. If you invest wisely the chances of “blowing up” (losing all your money in your investment) on a long term investment are much smaller but traders face this risk constantly. Even if the stock market does not perform over longer periods of time e.g. 10 years, you can still make money from dividend paying shares over this time. Dividends make up more than 50% of the total returns earned by equity investors over the long term. This is one of the reasons I favour value investors, they have a real focus on dividends rather than the “growth story” of a company.

 

85 Years of SA Stock Market Returns

Source: I-Net, compiled by Nedgroup Investments

 

 

The excellent graph above was created for me by Anil Jugmohan of Nedgroup Investments and I think it argues the case for long term investing in one simple picture. The blue line shows the performance of the JSE from 1925 to the end of 2009. The red line shows the high water mark of the market over this time. As you can see, patient investors who bought the market and held it through the bad times have always been rewarded for their patience because the market always breaks through its high-water mark again.

Conclusion

I acknowledge that trading as an investment philosophy has its merits, there are thousands of people who have made a fortune through trading. At the same time there are many, many more people who have lost everything and now work in other industries trying to make a living. If you are managing your own money and would like to have a higher probability of growing your capital over your lifetime then I would favour a long term approach over a trading philosophy. Consider the case of Nassim Taleb who is no longer a money manager. He has not retired to his private tropical island to count his money, instead he spends his life on aeroplanes and in hotels writing books and giving workshops – not much of a life if you ask me!

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