Education policies

Parents of young children often buy “education plans” that are sold to them by life assurance agents. The sales pitch is quite simple and powerful – you need to start saving to ensure that you can afford to send your beloved child to school. Often mention will be made of how bad the public education system is and that private schooling is the only viable option for parents who really love their children. Whilst I like the principle of saving for your child’s education, there are easy and cheap options that are often much better than these “education plans”.

What is an education plan?

Education plans are quite simply endowment policies that have been packaged by the marketing departments of life assurance companies. You can buy an education plan and use the money for any purpose; they have no special dispensation or tax rebates, they are just ordinary endowments. Given our current tax regime, I feel that endowments are better suited to wealthy individuals and Trusts because they have very high Income Tax and Capital Gains Tax rates. If you are not at the highest tax rates, you probably won’t derive much tax benefit from an endowment. Whilst it is true that the proceeds of an endowment policy are tax free once it has matured (i.e. been going for five years or longer) the endowment pays Income Tax and Capital Gains Tax at quite a high rates of tax within the policy. I often recommend endowments to wealthy individuals or trusts but only when the cost of the endowment is totally subsidized by the fund manager and only when there are no initial costs/commissions to the endowment.

Education plans are sold by life assurance companies and they inevitably carry an upfront cost/commission as well as a pretty hefty annual cost. Unfortunately these costs are not easy to understand. By my calculations, the annual costs range from 3% to 5% per year and the upfront costs are usually similar. I feel that these costs are far too high and ultimately make education plans a poor choice for education saving.

What are the alternatives?

FUNDISA

Government, ASISA and a selection of financial companies created an investment called FUNDISA http://www.asisa.co.za/fundisa/ that is designed to help people save for a child’s tertiary education. It is a good alternative for people who can only afford to save small amounts – the minimum starts at R40. Government will top up your contributions to this scheme by adding 25% to the amount saved annually BUT only to a maximum of R600 per year. The annual cost is reasonable at 1.25% + VAT and given the low minimum investment amounts, it should certainly be considered by those who can afford to save small amounts. It is important to note that the money can only be used for approved tertiary institutions. In addition, the underlying investment is an income or money market unit trust. I feel there is nothing better available if you are investing less than R300 per month and is certainly better than an education plan, in my view.

Exchange traded funds (ETF)

Regular readers of my articles will know that I am a huge fan of ETF’s. If you are not familiar with them, here is a link to the JSE’s website to read more.

When close friends or relatives have a child, I always suggest that they open an ETF account for their child. This is an ideal way for the parents to start saving with a monthly debit order and their friends and family can contribute to the investment on the child’s behalf. I think this is a great investment for debit orders and lump sums of R1,000 or less. If you are saving larger amounts, you could consider a stock broking account to buy your ETF’s.

Unit trusts

If you are not a fan of ETF’s, a well managed, low cost unit trust is also a good alternative. Just make sure that the annual costs are less than 1.5% per year and that you are invested in the right type of fund. If you are saving for a period of 10 years or longer, you really should be invested in a high equity fund.

RSA retail savings bonds

If you have been a bit slack in starting your savings for your child and have a limited amount of time to save, consider the RSA Retail Savings Bonds. They have no cost and your interest is guaranteed by Government. This is ideal for people who are going to need the money within three years or less.

In summary, it makes sense to start saving for your children’s education as early as possible. In fact, you are foolish not to do so. However don’t be suckered by the first life assurance agent who plays on your emotions to sell you a policy. You have many great alternatives.

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What to do with the holiday home

Holiday houses rarely prove to be dream investments and often become a burden and source of frustration to their owners. With the sad state of the property market, there is little point in selling this investment so here is an idea to get some benefit from a problematic asset.

Swap it

Let’s face it, if you bought a holiday home on the SA coast in the late 1990’s or early 2000’s with the hope of making money on the booming property market, you are probably regretting your decision now. Not only is the price of your property stagnating but it is costing you real money in maintenance costs and property taxes and interest if you mortgaged the property. If the property is a lengthy distance from where you live, you are not able to enjoy the use of the property as much as you would like. If you find yourself in this unfortunate position, you should consider making use of the property to get some low cost overseas holidays for you and your family by swapping your house.

People have been swapping homes with strangers for decades. The first house swapping company was started in the 1950’s and the world’s largest home swapping business has more than 40,000  properties in 140 countries – South Africa included. You normally pay an annual subscription fee to list your property and to see other properties listed around the world. Some of the businesses offer a rating system where the property and the owners can be rated. Once you have identified a property, you will then contact the owners directly in order to negotiate a swap. This is not a quick exercise like booking a room in a hotel but sometimes you can negotiate the use of a vehicle or cleaning service and it will give you a chance to get to know the other owners a bit better.

Benefits

If you have children and would like to introduce them to some other countries around the world, you will quickly realise that hotels are very expensive when you stay in a major city like Paris, London, New York or Hong Kong. In fact, your accommodation costs will be expensive in most cities. If you arrange a house swap with someone in a major city, you might be able to swap your 3 bedroom holiday house for an apartment in the city. This will cut out a major portion of your holiday cost and make overseas travel more affordable.

One of the great benefits of doing a house swap is that you can experience a city like a local. Hotels are often situated in “downtown” locations which are more suited to business travellers. On weekends these areas become very quite and are not suited to vacationers. In addition, you pay inflated prices for everything as people try to profit from tourists at every turn. By staying in someone’s home in a residential area, you will pay normal prices which will further reduce your costs. If you like to travel overseas, especially on longer holidays, you might find that your savings make the costs of your own holiday house more palatable. In addition you can still stay in your holiday home when you choose to do so. This seems a much better proposition to me than timeshare which is expensive and restrictive.

Be careful

As with any form of “direct” holiday arrangements, you need to be prepared to do some homework in order to get the cost savings. I would suggest that you use one of the larger house swapping businesses and try to use properties that have been reviewed or rated by others. There are many different businesses offering a listing service, the links below are some examples:

www.homeexchange.com

www.houseexchange.org.uk

www.aussiehouseswap.com.au

Before embarking on this exercise, you should contact your insurers to make sure that there are no problems with doing a house swap. If you are not charging for your home, it is not considered a commercial venture which means that you should not be charged more for doing a house swap.

When selecting a potential property, make sure that the property is suited to your requirements. If you are looking for the big city experience of New York, make sure that you are not staying in an apartment which is 90 minutes commute from the places you want to see. Local commuting is not cheap and if you are relying on public transport, you do not want to spend three or four hours per day travelling. Similarly, if you are looking for a quiet beach holiday in Spain, make sure that you don’t stay in an area that is inundated with inebriated partygoers every day in their summer holidays.

Try to get a friend or neighbour to hand over keys and check in on your “tennants” whilst you are away, this should give you some piece of mind and ensure that someone keeps an eye on your place.

I am not an advocate of buying holiday houses and would certainly recommend that people sell their properties if they need the money. However, house swapping does seem like a good way to make lemonade from your lemon.

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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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Three steps to financial freedom

I was recently asked by a student why it is so important to spend so much time and energy on savings and investments when it seems like investors get no reward for their efforts. The point was made that people derive pleasure from spending on holidays, clothes, cars and entertainment, so why invest? This is a great question that most of us deal with every day in our own lives when we decide whether to buy, spend or save. Without a clear goal to inspire us, most people will spend – not save.

What is financial freedom?

The final step towards financial freedom is when the income from your assets exceeds your expenses. Financial freedom is quite different from being wealthy because some people have financial freedom with an asset value of R5m whilst others who have assets of R50m are not financially free. It is not possible for everyone to become truly wealthy (despite the Hollywood fairy tales) but anyone can be financially free. I have met many people who have retired with relatively small amounts (under R5m in investments plus a paid off home) who are living fantastic lives as retirees. The real secret to their success is that they have accumulated sufficient capital to cover their expenses and they have controlled their expenses.

There are various degrees of financial freedom – I think the first step towards financial freedom is when you are debt free. Most people struggle to get past this step because they constantly increase their debt burden as their income increases. The average high income earner in South Africa is three months away from financial difficulty in the event of a loss of income because of this behaviour. They buy more expensive vehicles and houses because they can afford the higher monthly payments but they never pay off their debt until it is too late. If you can break this debt cycle by limiting your debt and paying it off more quickly as your income increases; you are already 80% of the way to financial freedom.

The second step in financial freedom is to build an asset base. The first asset you need is an emergency fund that you use in the event of a financial disaster. You should aim for an amount that is equivalent to half your annual expenses and this should be saved in a fixed deposit or 30 day notice account.

The third step is when you start building your income generating assets that will eventually pay your expenses in future. This is the step that most people focus on i.e. where is the best place to put your money to get the most growth with the least risk. There is one implicit aspect that most people ignore about this step; you must continue to spend less than you earn – try to save 15% of your total annual salary. It is important to understand that your initial capital will take the longest to build because you do not have the benefit of compounding yet. As an example it will probably take about 8 years to save your first R1m but your second million will only take 5 years and your third will only take three years. This is because of the effect of compound growth and not because you are saving more. Your greatest allies in this phase are patience and discipline.

Financial freedom is possible for anybody

If you need R10,000 per month to cover your expenses you only need R2.7m of investments to be financially free for the rest of your life. This is the real key to financial freedom, try to ensure that your expenses are really low and you will be in a position where you don’t need a salary far earlier than you think. I realise that most people don’t want to live on R10,000 per month but if you get to this position, you will be able to make better decisions about your life without worrying about a salary. Most people who reach this position are able to change their lives substantially – these are some of the reasons why:

  • You have less stress because you don’t have to generate a salary every month,
  • You have the freedom to do the work you choose e.g. start a business,
  • You can do a job you like, rather than a job you hate that pays better,
  • If you have a lousy employer, you can quit.

The only way you will have the necessary patience and discipline to take the three steps to financial freedom is if you give yourself a goal to work towards. Try to identify what will motivate you to spend less every month and not to buy the biggest best car you can afford. Make this goal your mantra and every time you get the urge to spend think of your mantra, within a few years, you will be on your way.

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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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Life Assurance needs a shakeup

The life assurance industry in SA is ripe for a shakeup similar to the way Capitec is transforming the banking industry. Despite all the efforts of the regulators through legislation like the Consumer Protection Act, the life assurance industry is carrying on as they have always done with opaque products, exorbitant costs and flawed remuneration models.

Upfront commisions are immoral

There is no shame in selling life assurance products to people who need the protection. In fact, good life cover can mean the difference between financial security and poverty for some families after a tragedy. At present, the problem lies in the way that people are paid to sell these products. The entire industry is geared towards paying advisors an upfront commission for selling a long term product. When an advisor sells a life policy with a 30 year term, there is minimal financial incentive for the advisor to service that person for most of the life of the contract because the advisor gets the bulk of his remuneration in the first 2 years. If an ethical advisor wants to offer life assurance products and is prepared to earn the income annually, there is no way to do this. Life assurance companies will only amortize your upfront commission and pay it to you over 24 months.

This makes no sense to me; we all know that people need to be incentivised correctly in order to do the right thing. Humans naturally follow the path of least effort when it comes to their jobs unless they are incentivised to act differently. In this instance, advisors should be paid a monthly fee for servicing their life assurance clients. If the client cancels a policy or changes advisor, the income should stop. Most agents who make a living from selling life policies will tell you that they cannot afford to earn a living without upfront commission. In addition, they will tell you that it will be the low income consumers who will suffer if we change the remuneration model because it will not be profitable for advisors to deal with them.

This argument holds no water. The short term insurance industry (insuring cars, houses etc.) has thousands of agents who look after the broadest spectrum of clients. All of these agents have a direct monthly incentive to keep their clients happy and to ensure that they are properly serviced. If this industry has a revenue model that can be applied to any type of client; why won’t it work for life cover?

One is sympathetic to agents who have always earned their income from upfront commission ,however the industry needs to make the change to protect the consumer. This does not mean that you cannot find a way to make the transition easier for these agents. The remuneration model can be changed over a few years where life companies start paying advisors over progressively longer periods so that their income is not too severely affected. Over the long term, any advisor who only earns income on a monthly basis will run a much better business because there is more predictability of income. In addition, clients will be happier because they will receive better service, this leads to more referrals which leads to increased income for the agents.

The products are too complicated

This article is an open invitation to Capitec or someone like them to look at life assurance as their next service offering. Life Assurance companies in SA have specialised in making their products overly complicated which makes comparisons very difficult. Numerous international specialists have looked at the domestic industry and advised them to offer more simplified products but this advice has been ignored. In my view, this is a situation that Treasury (Government) should be looking at more closely.

As an example, it is nearly impossible for any non-specialist to understand the differences between different severe illness benefits from the life companies in SA. If you get cancer, one company will pay you from the time you have been diagnosed whilst another company will only pay in stages depending on the severity of the cancer. Who knows how soon you should be paid after you get cancer? Surely there is a method that is best for the afflicted person and surely this should be the way that all companies pay out their benefits? By implication, it means that some companies are doing what is best for themselves not their clients.

As a start, someone with the right knowledge should look at all these different benefits and provide us a model for the best range of benefits that we need for life, disability and illness insurance. From there, we need to instruct the life companies to standardise their terminology for these benefits so that we can compare them and make a slightly more informed decisions when choosing the right product. As we have seen in the past, the life assurance industry does not like this type of transparency, (just ask Rob Rusconi) so I am convinced that they must be forced to change because they will not do so on their own.

Until then, I am fearful for those who need life assurance and related cover. You need to find a highly experienced and ethical specialist and there are only a handful of those.

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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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