Personal Finance 22.3.2016 02:15 pm

Diversity and patience – the secrets to real wealth

Image courtesy stock.xchnge (PocketAces)

Image courtesy stock.xchnge (PocketAces)

There are no substitutes for diversification and time.

Most people underestimate the impact of inflation. Although we might see prices rising from year to year, it’s difficult to get a feel for the real effect over time.

To illustrate how inflation erodes the value of your money, consider what R10 000 would be worth in today’s terms if inflation stays at 6%. In ten years, it’s buying power would have diminished to the equivalent of R5 584, and in 20 years it would be down to R3 118. In other words, at the upper end of the South African Reserve Bank’s target inflation band, your money loses just less than 70% of its value in two decades.

“And as we know, very few people actually experience 6% inflation,” adds Graham Tucker, portfolio manager at Old Mutual’s MacroSolutions boutique. “If you have children at school or are paying medical costs, you are a experiencing a higher rate of inflation and your money is eroding even faster.”

It is therefore critical that any investor thinks about growing their money in real terms. In other words, seeing returns above inflation. That is the only way in which you are actually growing your wealth.

In this respect, MacroSolutions does a lot of work looking at the historical returns from different asset classes, and their expected returns going forward. This sets the framework for putting together portfolios that will meet the objectives of generating real returns.

Critical in this is selecting the right mix of asset classes. The below chart illustrates the historical annualised returns after inflation of the main asset classes available to local investors between 1929 and 2015.

It also shows the return of the MacroSolutions Balanced Index over this same period. The index is not one of the boutique’s funds, but a theoretical representation of the typical asset allocation of a pension fund.

Annualised real return since December 1929 – December 2015

PAT 1

Source: Old Mutual Investment Group, MacroSolutions

 

As would be expected, equities have offered the highest returns, and cash the lowest. However, there is more to this story.

Using the long term average returns of these asset classes, MacroSolutions is able to calculate how long it would take to double the real investment value of one’s money. In South African equities, this would take nine years. In cash, it would take 92 years.

Using historical returns, it is also possible to plot how often an asset class has been the best performer over any calendar year. Looking only at the local market, equities are the best asset class 48% of the time, while cash wins only 13% of the time.

In other words, while you would see the best returns from equities every second year, cash is only the best place to have one’s money in one year out of eight.

“Different asset classes work at different points in time,” Tucker says. “Equity is not always the best performing, but it wins in the long term. If you leave your money in cash you might feel good in the one year that the market falls, but you are going to miss out the rest of the time.”

The below graphic shows how different asset classes have performed relative to each other over the last 50 years. Over the very long term, it is clear that equities show consistently high returns, while cash has given the lowest.

In the shorter term there is more variance, with different asset classes performing in different years.

 

PAT 2

Source: Old Mutual Investment Group, MacroSolutions

 

What is evident, however, is that the balanced solution consistently delivers returns in the top half of the table and ahead of inflation.

“This is why having a diversified portfolio is key,” says Tucker. “Asset classes move around a lot and its hard to predict what is going to be the top performer in any one year, but a balanced solution puts you in the top half consistently.”

Macrosolutions believes that this will continue to be the case, but that investors should expect lower returns in general over the next five years. The below graphic shows their outlook for different asset classes from 2016 to 2020 against their historical returns.

 

PAT3

Source: Old Mutual Investment Group, MacroSolutions

Note: Global equity returns are shown in US dollars so do not take currency movements into account.

 

What is evident is that South African bonds are the only assets likely to offer returns noticeably above their long term average. The outlook for cash and global equities is marginally positive, but this is more than offset by the much lower returns investors can expect from the local equity market.

“While a 4.5% real return might seem attractive from local equity, historically you have seen 7.5%,” says Tucker. “What has happened is that the fantastic returns we have seen in equity from 2009 have actually stolen returns from the future.” 

Even given this slightly more subdued outlook, however, investors with a long term plan will still be well served by a well-diversified portfolio. The critical thing is however to stay invested and give your money the time to grow.

“Nowadays you get bombarded with information on an hourly basis,” says Tucker. “But you are not going to get rich quick out of investments. Everyone has a friend that made a lot of money in this or that in a very short period of time, and that sort of thing will happen. Even a stopped clock is right twice a day. But if you want to have the best chance of growing your real wealth, that takes time.”

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