I read and watch a lot of news – It is important to stay informed in my role.

It is also important to be able to differentiate fact from fiction, news from opinion and emotional media baiting from something useful we can use and implement in our own lives.

This last year we have been bombarded with newsflow around the pandemic. From knowing precisely nothing to being coached by epidemiologists and other experts from all over the world daily. I strove to make sense of it all. I wanted answers.   

The problem is that the more I learned the less I felt like I understood. I think this is because the information was not always complete or so-called experts would contradict one another. I think commentators simply did not (could not) have the answers, so they defaulted to the next best thing, they spoke about it from a position of knowledge based on past experience.

The end result is that you either landed up with an illusion of knowledge – you believe you understand the facts and stop seeking out evidence to the contrary. Or the other option is to actively avoid any news whatsoever – because you can’t work out what to believe you opt to disengage from the process entirely.

Both of these behaviours are sub-optimal and potentially lethal.

The world of money management and investing is the same.

The information we get about investing is often quite one sided. Watching the financial media is not helpful. When markets are on a tear, the newsroom is commonly filled up with commentators wisely explaining why the current rally has more legs and how this time it is different. They can make a compelling argument.

When the markets crash, those same newsrooms are filled up with the “I told you so” commentators which were amongst the select few who ‘saw this coming’…. They too sound wise and all knowing.

The tricky part for us to grasp is how they looked at the same data and came up with a different conclusion.

Both will be right and both will be wrong at some stage…. 

Things that we believe one day, turn out not to be 100% accurate the next. Things change. Markets change. New products, new regulations, new taxes and new government policy mean what we believed today may not be true tomorrow, or perhaps not as true. The information is incomplete for just about every situation.

I guess when you try and simplify a relatively complex subject you run the unavoidable risk of leaving stuff out.

There is no perfect investment solution. There is often not only one right way of getting to a desirable outcome. There are ways of mitigating the uncertainty but not eliminating it.

Having a process and framework through which to navigate this uncertainty can make it more bearable. Being able to add or change variables when the facts change, allows us to answer questions like; How does this affect my current plan/life? Do I need to do anything? Can I do anything better? What are my biggest risks?

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Just in case you don’t come from a finance or investment background, the concept of a risk free rate of return is the foundation of return expectations for just about anything you could invest in. Let me explain.

As a reminder “returns” are what you get for letting someone else use your money.

So if I know I can let the bank use my money and they will give me R7 for each R100 that I let them use each year (7% return), I am unlikely to let someone else use my R100 unless they pay me more. Afterall I am almost certain that my money in the bank will still be there when I need it…. it could be referred to as risk free or alternatively the risk free rate of return. 

How much more I expect anyone else to return to me depends on how long they want to use it and the probability that I will get my money back when I need it or indeed at all. 

If I invest in shares I basically agree to let the companies I invest in use my money indefinitely. I accept that in return I own a portion of their profits but I have no certainty that those companies will generate profits or indeed even survive. 

To invest in shares I therefore require a much higher return than the “risk free rate” I receive when letting my bank use the money. Using a little art and a little science let’s agree that I would let companies use my money if they paid me the risk free rate (same as my bank) plus another 5%. So l invest in shares rather than leave cash in the bank if I could reasonably expect I would get 12% (7+5)  for letting them use my money rather. 

Here is the problem….. the risk free rate is linked to interest rates. The bank may have paid me close to 7% at the start of 2020 but they are only going to pay me 3.5% now, because the South African Reserve Bank (SARB) have cut interest rates significantly in response to the pandemic.  

My return for letting a company use my money must reasonably now be 8.5% (3.5+5) instead of 12% (7+5).  I am still being compensated by the same amount over and above the risk free rate. 

For my expected returns from shares to fall to 8.5%, one of two things must have happened:
1. Earnings from my shares stay the same but the price I pay for the shares goes up.
2. Earnings from my shares go down and the price I pay for the shares stays the same. 

Basically what has happened is as the returns from cash have fallen, investors have become more comfortable paying more for their shares and accepting lower future returns as a result.

Bottom line is that future returns are likely to be lower going forward for just about everything you can invest in. With interest rates near zero and bond yields negative in many cases in the developed markets,  the concept of return free risk is now a reality and creating all sorts of problems around how to decide what to invest in and when.

What does a low yield environment actually mean for you?

When you build an investment solution to target a specific objective or goal you have an implicit return expectation that you need to achieve in order to reach your goal.

Lets say we needed to have R1000 in 20 years time. We have R100 to invest today and could put another R10 away each year. When you run the numbers you will find out that your investment will need to grow (a return of) at 9% per year to reach your goal.

 The next step in your strategy would be to choose investments (the broad asset classes being cash, bonds, shares, property) which are expected to deliver that return over time. Simple enough. 

The problem we face is that this pandemic, and specifically the responses thereto, are lowering the  return expectation on basically everything you could invest in. Crucially the future returns may be significantly lower than we have been projecting when putting together solutions. 

If we were expecting 9% in the past (example used above) and now the return is closer to 4.5%, it means in order to still have R1000 available in 20 years time:

– You need to put away R24 per year instead of R10. 
– You need to have saved up R285 to invest upfront rather than the R100 you now have. 

Your other options are to:
– Accept that you will reach your target of R1000 in 30 years instead of 20 years. 
– Accept that 20 years from now you will have R555 instead of R1000.

None of these options are particularly palatable in terms of our planning process.

Perhaps the obvious solution is simply to take on more risk to keep our returns closer to the 9% level than the 4.5%. The unwelcome truth is that taking on more risk does from not always lead to higher returns as can be seen in the graphic below which shows how R100 has grown when invested in broad South African asset classes over the last five years. 

The truth is that managing this process probably requires making adjustments in your personal finances, your expectations and your investment strategy.

Even if you are one of the lucky minority who have not had your income impacted by this pandemic, you may still have to divert more of your disposable income to your investment goals in order to achieve them in the time horizon and to the same extent to which you had initially planned.

So next time you look at your bond statement and are high fiving the lower repayment charges, remember with one hand interest rates giveth and with the other they taketh away…. maybe you even need to divert the savings on your bond to boosting your investment contributions if you can…

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In the next in our series of simple ‘concepts that can change your life’, we consider the true cost of the every day decisions we make in the context of good long-term financial outcomes. 

Do you never seem to have any money to invest?

 

Are you squandering opportunities to create wealth by the active decisions you make daily?

Over the course of our lives many opportunities are missed as we sacrifice real wealth creation for the perception of wealth.

Understanding that the true costs of the decisions that we make are greater than the sum of the individual cash flows is crucial. 

The power is in your hands – Choose wisely!

Choose wealth creation!

 

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Whether you know it or not, if you have a proper investment plan in place you have made (or hired someone else to make on your behalf) some rather large assumptions about the future.

One of the first steps towards saving and investing for a future goal is to have an idea of what that future goal will cost at the point in time when we need to pay for it. From this point we can determine:

– how much we will need to contribute,

– how much we will need to earn (investment returns) on our contributions

– and what type of investments we will need to purchase to give us the best chance of achieving our goals.

In financial parlance we get to the answers to all of these questions through a process called financial modelling – A financial model is a tool designed to help quantify future goals and better quantify what we need to do to get there. A financial model will also provide a framework against which we can measure our progress over time.

Since no one has the ability to accurately predict the future we have to make some assumptions or educated guesses about certain future outcomes that go into the model.

Herein lies the greatest risk and weakness of a financial model – You can get it to tell you pretty much anything  you want to hear based on the assumptions that you choose to use.

The quality of the inputs directly correlate to the quality of the outputs – In other words what you put in is what you get out so it’s a good idea not to use rubbish assumptions.

Whether you use a financial advisor, a robo-advisor or have gone the full DIY route you should be aware of and understand what assumptions your plan is using when projecting your future financial outcomes.

A more sound knowledge of these factors should allow you to create plans with outcomes which are likely to be more accurate and therefore beneficial to you long-term. You should also be in a position to identify when sales people are merely using pie in the sky assumptions to flog more product.

With a few working examples we hope to shed some light on two of the more common areas of modelling risk that are likely to impact on your investment plan.

In our working example let’s assume my goal is to pay for my 8-month old son’s high school education. I would like him to attend a reputable non-private boarding school  – The 2016 fees for this institution (tuition & boarding) is R95,000 per year for Grade 8-12.

What I really want to know is what I need to be putting away monthly now in order to have the full fees available by the time he starts his Grade 8 year, which incidentally will be the year he turns 14 (2030).

The two most important assumptions I have to make involve:

(i) Inflation

(ii) Investment Returns

Inflation – I need to know at what pace the 2016 fee likely to increase over the next 14 years?

Of course inflation is not something that is in my control – The school will set their own fee adjustments annually and can range anywhere from 7.5% up to 12% in my experience.

Inflation increases costs at a compound rate so I have got to understand that over a 14 year period seemingly small differences in percentage terms can actually have a massive impact on the quantum of my end goal.

So if I assume an increase of 6% then my Grade 8 cost in 2030 is about R215,000 or a total high school cost of R1,211,000.

But if in reality the cost of my chosen school rises by 9% per year then the Grade 8 cost will in fact be R317,500. The total high school cost at this rate would be R1,900,000.

Feeding that through to my original question of how much I must be putting away monthly to get to my target it becomes clear if I use 6% in my financial model, I will need to put away about R2,700 per month. But if I used a more realistic 9% increase, I will need to put away R4,200 per month (Both assume a 12.5% annual average return).

Using a 6% increase is therefore more manageable monthly but I will be about R700,000 short of the real target if I follow through with this assumption.

Investment Returns – What pace can I reasonably expect my savings to grow at over the next 14 years?

The rate of return that I assume I will receive on my invested contributions will similarly impact on the amount I need to be putting away.

The investment return assumption I input into my model must crucially be on an after fee basis to reflect a more genuine actual rate of compounding. For example, if equity markets are expected to deliver 14% per year then each percentage point of fees that I pay to various parties will serve to reduce my actual returns and therefore increase the amount I will need to contribute on a monthly basis. 1

The actual returns I receive will depend on market conditions and the mix of assets that I use with my portfolio or my asset allocation.

For the purposes of this illustration I will use three levels of returns, which will somewhat clumsily fit into the definition of low, medium and high risk as per the conventional naming methodology. 2

So for the low risk option let us assume a pure cash play with a return of 7%.

For a medium risk portfolio  we will use the average return of the medium equity fund group over 15 years, which as at end of March 2016 was 14.0%.

For high risk we’ll use the average return of the FTSE JSE All Share index over 15 years less 0.5% which is around 16%.

At each level of assumed returns my required contribution amounts look like this:


What is evident is that safety and consistency of returns comes at a price.

– If you want to invest in a low risk fixed return portfolio you will simply have to contribute more to get to your target.

– If you opt for a high risk portfolio then you will need to be clear upfront that your portfolio is going to fluctuate in value quite considerably throughout the life of your investment and there is no guarantee of the final return.

Finally to sum up the message here and to give the clearest illustration of how you can get a model to tell you what you want to hear I have compiled the best and worst case outputs.

Best case – The Product Floggers model

Inflation at 6% and investment returns at 15.5%

A product flogger wants to sell more product and can make the goal easier to achieve and therefore more attractive to potential buyers by using the best case scenario assumptions.  It is not illegal, it may perhaps not even be considered strictly unethical BUT it is most certainly not going to help their clients to actually reach their goals.

Worst case – The Haters model

Inflation is 11% and investment returns are 7%

There are haters out there of course. Those that have previously had bad experiences in the investment market or perhaps have been sold a product floggers model before and feel somewhat aggrieved by the fact that it was doomed to fail from the start. They want to prove that planning and investing is for the birds and so they use the worst combination of inflation and investment returns to make their case.

The truth is the actual outcome will fall somewhere in between the best and worst case. The exact degree is unknown and unforecastable hence the need for assumptions. Financial targeting is necessary but one needs to monitor and know how to adjust the solution if the assumptions prove wayward.

1As discussed in previous write ups, one can make a strong case for arguing that cash is a high risk investment option over the long-term in that it very rarely maintains your purchasing power.   
2Taxation will in reality also serve to reduce the real returns that you achieve on your investments but I have not included this discussion here as it get’s a little more complicated and long winded while the message remains the same. We need to understand what the real returns are after fee’s, taxation and all other costs.

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The best way to get something done is to begin…

If procrastination is the thief of time, and time is one of the biggest advantages you have when investing, what are you waiting for?