This is a follow-up article to my previous writing, in which I highlighted some of the most common mistakes made by investors managing their own investments. I hope that my earlier article was valuable to investors and that this one will also draw attention to some factors to consider when investing.

These are the next 10 common mistakes investors make.

Misunderstanding the taxes within different investments

Various taxes are involved, not only across different asset classes but also within different investment types. Taxes range from the tax deductibility of contributions to retirement annuities (RAs) to tax-free returns on tax-free savings (TFS) investments and income from interest and bonds, which are taxed as regular income.

When funds are structured as “roll-up” funds, these taxes are not paid annually but only when the funds are sold, at which point capital gains tax (CGT) applies. This is because the interest component is “rolled up” into the unit price of the fund, and CGT becomes payable on the capital appreciation of the asset.

One of the biggest mistakes is using the declared return of high-interest funds, such as income funds, for long-term projections, ignoring the reduction in yield due to taxes. 

When these funds are held in TFS and RA funds, the full return can be used in the calculations since they are tax-exempt.

Too many administrators are used

Most administrators calculate their administration fees by aggregating the investments across all products and holdings of an investor on their platform. Some administrators even go so far as to combine the investments of spouses, resulting in lower fees for both parties. By using different administrators, this advantage is lost, leading to higher administration fees that become payable.

It makes sense to find an administrator that can meet all your needs, or as many as possible, to secure the most competitive administration fee. However, be cautious; not all administrators are equal. Seek one that has robust systems and user-friendly functionality, along with a strong track record at a reasonable price. Fund availability also plays a role, depending on your objectives.

Not understanding the administrator’s functions and roles

Administrators are precisely that: administrators. They are not advisors, and they will not provide you with investment advice unless they are licensed to do so. As far as I know, none of the SA administrators hold a licence to give advice. Life assurance-linked administrators may offer you advice through an agent force, but that will most certainly not be complimentary advice.

It is also important to understand that if you own discretionary investments on a platform, those investments belong to you. Even if the administrator goes bust, those underlying investments are in your name and do not form part of the administrator’s balance sheet. The administrator only has a claim to an administration fee, not your investments.

When investments are held in an RA, endowments, or any other life-linked product (such as certain TFS investments), the underlying investments belong to the product that holds them. If that “holding fund” or product fails, you become a creditor to the fund and must lodge a claim against it. RAs and pension products do offer additional layers of protection through legislation and government safeguards, making the likelihood of one of these “parent products” failing highly unlikely.

I merely mentioned the technicality to clarify the role of the administrators; it was not my intention to make you anxious. Nevertheless, you still need to ensure that the fund you invest your hard-earned money in is robust. Rather stick with well-known funds and investment houses. Where you venture into the “unknown”, ensure the investment team is sound and that the fund is registered with the FSCA. 

Herding effect

There is a prevalent trend in which many investors hold the same funds. This, in itself, is not problematic; one would expect robust funds to have wide appeal. However, it appears that some fund managers excel at marketing more than others. It is also evident that when new funds or themes are promoted, they are incorporated into existing portfolios. This does contribute to the issue of holding too many funds, which results in a dilution of overall portfolio returns.

A more concentrated portfolio offers better opportunities for outperformance. Alternatively, one could simply invest in a passive fund that aligns with their investment objectives. It is interesting to observe how one can track investments into funds based on their short-term performance rankings. This situation is far from ideal …

Some investors don’t understand the tax implications of foreign-held assets

Taxes that apply to offshore-linked investments vary from CGT to estate duty. CGT is paid on capital appreciation. Since feeder fund prices include currency movements, CGT is effectively paid on rand depreciation in feeder funds. Funds held directly offshore only pay CGT on the real capital growth measured in the hard currency. This effectively means that you will pay CGT on between 4% and 6% additional “growth” per year in feeder funds compared to their direct offshore “parent funds” due to long-term expected rand depreciation.

When one invests directly offshore, the unintended consequence may be that you incur a tax liability in a foreign country. This is further compounded in certain jurisdictions where additional estate duties may apply. Depending on your offshore holdings, situs taxes, where they apply, can more than double estate duty on foreign-held assets.

Don’t understand the sequence of returns

The sequence of returns can work either for you or against you. There are times when it makes sense to invest in volatile funds, but there comes a time when you need stability and consistent returns.

When you are growing your wealth and making monthly or regular contributions, you prefer markets to be volatile, and the sequence of returns can work in your favour due to rand cost averaging.

The opposite applies once you begin drawing income from your investment. At this stage, stability and consistent returns become crucial. The last thing you want is for your living annuity to enter a negative spiral for an extended period just as you begin withdrawing income from it. Portfolio structuring and loss prevention now assume a significantly more important role than they did during the pre-retirement capital appreciation phase.

Investors don’t understand the difference between volatility and risk

The simple explanation of risk is the likelihood of incurring a permanent loss. This is often more exacerbated by investor behaviour when clients disinvest at exactly the wrong times, typically after markets have moved downward. Volatility is normal in investments, and the more growth assets you hold, the more returns will move upward and downward as asset prices adjust, and this causes elevated levels of volatility. It is important to understand that solid investment returns can only be achieved through volatility and the inefficiencies created by various factors. An investment that just keeps on going up must be a concern. Most importantly, volatility is not risk.

Investors often fail to distinguish between volatility and loss

My first question to clients who indicate that their portfolio incurred a loss is how much they initially invested. It is common for investors to invest, say, R1 million, which grows to, for example, R1.4 million in two years and then drops to R1.2 million shortly thereafter. Many clients consider this movement a loss of R200 000 when, in fact, it is a profit of R200 000. The movement that they experienced was typical volatility. As long as the upward and downward trend ends up in a long-term upward cycle, the illustrated movement is perfectly normal for an aggressive portfolio.

The question is, how much volatility are you comfortable with? Your answer must determine your portfolio construction. Understand the volatility profile as well as the historic maximum drawdown of the funds you invest in. If you know and accept this, the normal volatility patterns for your portfolio should not bother you.

Investors measure returns against the wrong benchmark or no benchmark at all

Benchmarking is another touchy subject. The most common “measure” that investors use is cash or inflation. Cash is favoured by investors when markets are under pressure and taking knocks. Comments by investors about keeping their money under the bed become the order of the day when negative returns persist for extended periods.

It is crucial to understand why investments may turn negative at times. The only guarantee I offer clients is that if you hold any form of growth exposure (equities, bonds, property, commodities), at some point, the value of your investment will decline – guaranteed.

When your portfolio does decrease in value, it becomes essential to assess how it is performing relative to its peers. For instance, your investment might experience a 10% negative return while its peers or benchmark are down by 20%. In a declining market, that may constitute a very good outcome. However, investors often do not perceive it that way. They prefer to see positive returns consistently. The only way to ensure that is to invest in cash; all other asset classes will face negative returns at some stage in their life cycle.

One challenging benchmark to approach with caution is the “inflation-plus” benchmark. When markets falter, surpassing an inflation-plus benchmark turns out to be impossible. If this is your benchmark, be prepared for an extended period of unease, as equity markets can yield negative returns for several years during recessions or re-ratings following extreme performance.

Instead, consider using inflation-plus as your long-term investment objective, but select a benchmark that accounts for all your underlying assets. Typically, this will consist of various indices with different percentages of exposure, depending on the investment mandate. The simplest benchmark to utilise is one of the SA, or global multi-asset unit trust sector benchmarks that align with your investment’s asset allocation.

For equity investments, the relevant equity index, such as the ALSI40 or S&P 500 (for US investments), should be employed. Please refrain from using the S&P 500 as your benchmark if you invest outside the US. Instead, utilise the relevant benchmark for the country or region in which you are investing. If you are a true global investor, consider using the MSCI World or MSCI All Countries (if you have exposure to emerging markets) as your benchmark.

Competing with the Joneses

Receiving “hot tips” or listening to “my friend Jo,” who enjoyed remarkable returns, should be approached with caution. Similarly, we often observe readers commenting, “If you had invested in the S&P 500, you would have achieved 15% returns per year over the past five years.” While that may be true, did you actually invest in the S&P 500 during this time?

One consistently hears about the successful investments someone made, but rarely about the unsuccessful ones. It’s much like someone winning R50 000 in the Lotto who proudly boasts about it but never mentions how much they have lost over the years …

Next week, I will discuss 10 more mistakes that investors often make.

Successful investing to all.