COMMON MISTAKES MADE BY DO-IT-YOURSELF INVESTORS – PART 3

The biggest challenge investors must confront is overcoming their own biases and refraining from making decisions driven by emotions.

This is the last article, where I will discuss the common mistakes frequently made by do-it-yourself investors that I have identified. By noting the 30 mistakes I have covered over the past three articles and addressing them, most investors will likely experience a better outcome.

The biggest challenge that do-it-yourself investors, like all other investors, must confront is overcoming their own biases and refraining from making decisions driven by emotions. The greatest threat to wealth is associated with investor behaviour, and “going it alone” increases the risk of emotional decision-making. 

Many investors don’t understand what they are investing in

Many investors do not understand the fundamentals of various investment types and asset classes. Few can provide a clear explanation of how, for example, bonds operate and why the values of listed properties are influenced by interest rate fluctuations in a manner akin to bonds. Having a general understanding of what affects different asset classes aids in grasping why investments behave as they do during various economic and interest rate cycles.

Two current investment favourites among investors are gold and cryptocurrency. When I ask investors if they know what drives the value of gold and ask for their description of cryptocurrency, it becomes apparent that their interest in these assets is largely due to recent performance and not because they understand the assets fundamentally. Ultimately, if you do not comprehend the fundamentals of an investment or asset, it is advisable to refrain from investing in it.

Investing in scams 

I am always astounded when investors fall for scams over and over again. The sad thing is that some people have fallen for the devious tactics of scammers more than once. Even sadder is that often, it is individuals who cannot afford to lose money due to the limited capital they have. Desperation often causes people to take on risk that they should not consider. Seeing retirees who are in dire straits losing the last of their money both hurts and angers me. I understand that desperation drives them to try and achieve the best returns they can achieve. It often seems as if scammers target the old and vulnerable.

There are also those who fall for the promise of “super returns” purely out of greed. Them I pity less. If greed is your driver of investment decisions, you must accept the same odds as going to the casino. Then, if (when) you lose, the blame is on you.

Please refrain from investing in any product or investment scheme that promises super returns. Scammers often market “guaranteed” returns that mean absolutely nothing.

Investors don’t understand investment guarantees

If I personally offered you a three-year investment with a guaranteed return of 20% per annum, would you accept it? To make it more appealing, I would guarantee not only the return but also the capital. You cannot lose!

There are two things you must consider before entering into such a deal. Firstly, how will I invest the money to ensure a return of more than 20% per year? (Remember, I also want to make a profit, and the product wrapper incurs costs, so the actual return must be significantly higher than 20% per annum.) Secondly, how will I honour the guarantee if my strategy fails to achieve the 20%+ return per year? Frankly, if you accept my offer, the only guarantee you will receive is that you will lose your money if I cannot achieve a 20%+ return per annum over three years. 

Generally, these schemes are either pure scams in which your money is stolen or Ponzi schemes in which the money of new investors who join the scheme is paid out to old investors who qualify for payouts. These payouts “prove” the scheme’s sustainability and are then used as marketing tools to attract new investors who will lose their money.

Health warning: If the guarantees provided by any product or company are not backed by a large bank or financial institution, it is advisable to walk away. A guarantee is only as strong as its backing. Additionally, ensure you understand the suspensive conditions. Most guarantees include “subject to” clauses that are often tied to minimum performance requirements throughout the investment period.

All investment offerings to South African investors must be registered with the FSCA. At the very least, ensure that the company offering the “product” is a financial services provider (FSP) registered with the FSCA. This requirement also applies to foreign investments solicited to South Africans. Unfortunately, a registered FSP does not guarantee trustworthy intentions, as we often observe. Exercise common sense, and if anything appears dubious or seems too good to be true, investigate further or decline.

Use money market rates as a guide. If the general SA money market rate is 8.0% (what we also refer to as the risk-free rate), then any return above that must include some risk. Even guaranteed interest rates offered by banks should be questioned. Why can some banks offer “fixed deposit” rates of 12% for instance, if the risk-free rate (money market rate) is 8%.

Remember, banks borrow money from the Sarb currently at 7.5% (repo rate) and onward lend to the public and institutions at a rate linked to the repo rate. Banks also “borrow” money from investors and pay them interest linked to the repo or prime.

So, how do banks offer investors returns of 12% and sometimes higher? They lend to non-creditworthy investors and charge them prime + 7% and more. That means, for instance, they are earning 14.5 % interest (and more in some cases) and paying 12%, which results in a profit of 2.5%. 

These figures are merely for illustrative purposes. It is somewhat more technical than this.

The problem arises when the bank’s “non-creditworthy” book grows and these clients start defaulting. Remember the Great Financial Crisis (GFC) of 2007? The defaults of non-creditworthy lenders dragged the US and other major banks to the brink of destruction, and many banks were bankrupted.

Why am I telling this story? My suggestion is to always revert back to the risk-free rate or the plain money market rate offered by banks or unit trusts. Any guarantee above this amount must be questioned. 

Where guarantees are linked to bond yields, the same applies. More risky bonds provide higher yields. Make sure of the sustainability of the bond issuer.

Remember, guarantees are only as strong as the guarantor.

Misunderstanding taxes and processes during estate asset transfers

Some investors believe that whatever the estate value is will be transferred to them. The following costs must be borne by the estate (remember, a deceased estate is a legal entity and must fulfil its obligations:

• All debts owed by the deceased must be settled. If debt exceeds assets, the estate will be declared insolvent.

• Estate duty, income tax and capital gains tax (CGT) are payable by the deceased’s estate. Where a spouse inherits, estate duty and CGT get “rolled over” until the death of such spouse when the taxes become payable.

• Although transfer duty is exempt where property is inherited, the legal fees will still be payable.

• All debts must be settled before distributions can take place. 

• Where an estate owns only assets and does not have liquid assets to pay costs and taxes, assets will be sold, or beneficiaries must pay said duties in proportion to their inheritance.

• Beneficiaries do not inherit the deceased’s debts.

Health warning: The costs associated with settling an estate are often underestimated, and liquidity issues frequently arise. An estate containing high-value assets that lack liquidity can result in the disposal of assets meant to stay in the family. I recommend having an estate liquidity analysis performed to ascertain whether this is the case for your estate.

Investors don’t always understand the pitfalls of estate planning where assets are held in foreign jurisdictions

Although many countries have double tax agreements and treaties, the structure of how they are held and what instruments are in place to ensure their effective transfer is crucial. At the very least, have a foreign will dealing with your foreign assets. You will still be liable for estate duty on those assets in SA, but at least you can deal with probate and other issues that may be specific to the jurisdiction in which your assets are held. Make sure you know how the jurisdiction applicable to you operates and have the necessary documents in place to ensure the transfer of your assets goes smoothly. Be aware of additional taxes like the situs tax levied in the US and some UK jurisdictions.

Health warning: Avoid including the common clause stating, “this will replaces and supersedes all other wills,” in a foreign will. If your foreign will contains this clause and is dated later than your South African will, it will replace your South African will, resulting in various issues.

Investors don’t understand that trust assets don’t belong to them

In addition to the legal requirements for a trust to have a bank account and to record regular trustee meetings, the most common and dangerous practice is for individuals to treat trust assets as if they were their own. I recently read a reader’s question in which he claimed to have inherited a trust. You cannot inherit a trust; you can only be appointed as a beneficiary.

If you treat trust assets as your own (not only in use but also by instructions), Sars can set the trust aside and deem the assets your own. In the event of a divorce, it is not uncommon for a disgruntled spouse to claim a large portion of trust assets after proving that the divorced spouse did not treat trust assets “at arms-length” and that trust assets were dealt with on their instructions. 

If you are a founder/settlor of a trust, ensure you abide by the rules of the Trust Act. Make sure you have independent trustees, keep minutes of trustee meetings, and pass proper resolutions when decisions are reached. 

Investors don’t understand when volatility is your friend and your enemy

I have, in the past, frequently referred to the sequence of returns and volatility characteristics. While we accumulate wealth on our journey to retirement, volatility can work in our favour if we invest consistently and regularly. The rands we invest purchase units, the prices of which fluctuate daily. During periods when prices decline, more units are acquired with the same amount from our regular investment (debit order). When unit prices recover or surpass previous levels, we find ourselves “in the money” and make a profit. Rand cost averaging mitigates risk over time and indicates that it doesn’t matter when you begin investing if you do so through a regular debit order. 

Lump-sum investments are more cost-sensitive than monthly investments, and the price at which you enter the investment does matter. This is also why one should be more cautious, especially when investing to earn income. If the value of your investment declines shortly after you invest and you earn income from it, the results can be catastrophic. When unit prices reduce, more units must be sold to provide your required income. These units cannot be recovered. A strategy with less volatility is crucial to ensure the long-term sustainability of your income-providing investments.

Investors get buying and selling wrong

Carl Richards coined the term “The Behaviour Gap”. Essentially, this represents the cost investors incur by buying high and selling low. Research indicates that, on a global scale, “do-it-yourself” investors achieve returns of about 2% per year less than advised investors who invest in the same funds over a decade. This amounts to 20% less capital growth over the measured 10-year period. Investors tend to gravitate towards buying what seems successful; however, it is often the case that yesterday’s winners become tomorrow’s losers and vice versa. When a fund begins to underperform, resist the urge to panic and withdraw your investments. Instead, take the time to determine the cause of the underperformance. Familiarise yourself with the philosophy of your fund managers and appreciate how they differ from the market. This can be challenging, but it underpins successful investing.

Investors place too much value on their residential property – It’s an SA thing

South Africans are property bulls. Many investors I meet have a situation where the most significant asset in their portfolio is their primary residence. It also seems to be the mission of most investors to settle and pay off the bond as fast as possible.

Don’t fall into the typical SA trap of having a fantastic paid off home when you retire but far too few investments and capital to fund your retirement. The transactional costs (selling primary and “downscaling” to perceived cheaper property) often disappoint due to the elevated prices of retirement and security villages.

If you like property, buy a second and third property and let tenants pay it off. At least then you are creating a passive income stream and generating a future retirement income stream. 

Note: An asset can only be classified as a proper retirement asset if it is capable of generating income or if portions of it can be sold over a prolonged period to establish a sustainable long-term income stream. Unless you own and reside in a guest house, your primary residence should not, therefore, be considered a retirement asset.

Strive for a scenario in which your primary residence accounts for no more than 25% of your total asset base on your retirement date. The remaining portion should comprise rental properties, voluntary investments, retirement funds, and private business interests.

Investors don’t always understand how returns are declared

The period during which you measure returns is important. I often encounter remarks from clients who are thrilled with their impressive returns. However, those same clients frequently express disappointment regarding the returns from some of their other funds. Upon closer inspection, the reporting periods of the various investments are often not aligned, or there have been inter-fund switches in the portfolio that distorted the declared returns.

If you choose funds based on the information provided on fund fact sheets, ensure that all the fund fact sheets are dated the same. Although fund fact sheets display different return periods, they consistently indicate returns over the last 12 months and the subsequent 12-month periods preceding that. If the figures stated on one fact sheet are dated September and another October, an accurate comparison cannot be achieved. The 12-month returns of funds assessed each month can and do vary significantly. 

Health warning: While the returns reported on fact sheets are significant, they should constitute only a part of your consideration when selecting a particular fund. Learn how to analyse fund fact sheets. Additionally, bear in mind that fund fact sheets may not be current on the day of your investment. Fund managers typically publish fact sheets that are between one and three months old. Therefore, it is likely that the underlying assets displayed on the fact sheet differ from their actual status on the day you invest.

I trust that the 30 points I covered in the last three articles were beneficial. Knowledge is power. If you intend to self-manage your investments, ensure that you comprehend all aspects, from taxes to asset classes and the structures of the investments in which you place your hard-earned money. 

Best of luck with your investments. Most importantly, enjoy yourself and bear in mind that there is a distinction between investing and speculating.

Take care.