Contributing to your own success
Initiating your investment strategy by choosing the “desired” contribution level that you would like to make towards your investment goal is a little like starting a fitness regime by choosing the amount of exercise you would ideally like to do to get to your perfect target weight.
Let’s face it if it worked like that many of us would choose to do as little exercise as possible and eat what we like, as often as we like, and still be perfectly happy with our physical fitness and appearance.
In reality however, you choose a target weight you’d be happy with and then you have to go out there and walk, run, swim, cycle and even possibly crawl your way to your goal. You have to include the discipline to eat correctly while you are at it and accept that this is an ongoing process and not a once off event.
When it comes to putting an investment plan together many people start by stating an amount they would be happy to contribute in the hope of reaching a specific goal. Something along the lines of “ I can save R1,000 per month for my child’s education.” In fact when you read the marketing material of many of the large players they will often sell product with something along the lines of “ Save for your child’s education from as little as R200 per month.”
This approach has a number of pitfalls:
- There is no link whatsoever between the chosen contribution amount and the target value of that goal or objective.
- Most of us hope we can get away with saving as little as possible now, in favour of still being able to consume what we want. We tend to contribute as little as we think we can get away with.
- Making a contribution without putting it into context, by measuring it against the probability of success, often engenders a false sense of security about our future. We live in ignorant bliss because we can sleep at night by saying we contribute – only when it is too late do we discover it was not enough.
- A contribution level has an inverse relationship with the return required to achieve a goal. Choosing a low contribution level usually correlates with an unrealistic required return.
In my mind; if you are taking the time to identify and prioritise a life goal; if you are willing to acknowledge that this will take some sacrifice, effort and planning ; and then if you actually have the discipline to follow through with it; surely you want that plan to actually have some reasonable certainty of being successful?
The following case study is designed to better illustrate this point so that you don’t fall flat on your proverbial as you construct your financial workout regime for your next goal.
I have R50,000 today and I want to be able to pay for my son’s primary school fees in full in 6 years time. I estimate that the total cost of his primary education will be R240,000 at that time.
I can then consider and compare a number of monthly contribution rates against the return required to reach my stated target value as follows:
If I opt to pay R50 per month to achieve this goal, it means I am going to need a corresponding return of 25.8% (after fees) per year to meet my target. In fitness terms this is akin to saying I weigh 120kg now, my target weight is 70kg and I am willing to cut my MacDonald’s consumption down to only one a day, while maintaining an exercise regime that involves walking from my front door to the car. It is simply not based in reality.
Even the riskiest of portfolio’s is unlikely to get you that return compounded over 6 years regardless of how willing you are to accept risk.
If I concede that a R500 per month contribution is possible, my corresponding required return drops to 20.47% (after fees) per year. While more reasonable, this return expectation would require that the best equity market performance in history repeats itself over the next six years. From current market levels this is simply not likely. Added to which a 100% allocation to equities or property over a relatively short time horizon, such as 6-years, will run a significant risk of failure.
If I batten down the hatches and tighten up the budget strings even further, I may find I can get to a monthly contribution of R1500, which would correspond to a required return of 10.1% (after fees) per year. This return target is more reasonable and would perhaps be a good place to start. Note I still would not have any guarantees of success as there are so many other variables at play but I would certainly be in with a much better chance of succeeding.
Incidentally if my target value in 6 years time proves to be accurate (R240,000) then it would take a contribution of R2,640 per month to get to that target by stashing cash under the mattress. (That is to say not earning any returns at all from my savings)
What I hope becomes obvious from the discussion is that:
- Making a larger contribution increases the certainty or probability of reaching my goal.
- Making a larger contribution lowers the required return that I need to get to my stated target.
- Making a larger contribution reduces the amount of risk I am required to take to get to my goal.
So next time you are saving towards a specific life goal, try and link what you contribute towards that target with the probability of actually getting there. The contribution rate you make will infer a corresponding return that you will need to achieve. In turn this return will influence the asset allocation you will need to adopt in order to have a chance of getting to your goal. Of course the higher your required exposure to equities and property, in search of higher returns, the more you are exposed to volatility over shorter time periods (risk).
If you are unable to make the contributions which would allow you to get to your target with a high level of certainty, or indeed the level of required return implies an asset allocation which is not aligned with the risk you would be happy taking, then it is probably a good idea to stick with a plan that will only partially meet your objective. You can then proceed with full knowledge up front that you will have to carry the remaining burden at some point in the future.
There are few absolute certainties in an investment planning exercise – your target will move if you are wrong about the inflation assumption, your returns could also potentially be higher or lower than assumed. These are not factors that either you or your advisor can forecast or influence.
So managing a successful solution is about having a realistic starting point based on probabilities rather than possibilities. Reduce your risks and increase the probability of successfully achieving your goals by tending towards more conservative assumptions, higher contributions and by monitoring and adjusting your solution as required.
For more information on compiling a successful investment strategy give us a call or get a basic overview of factors to be considering from our educational write up “Developing an Investment Strategy.”