SMALL PERCENTAGES – BIG DIFFERENCES
We have all heard about the “eighth wonder of the world,” namely the power of compound interest. Have you ever considered the impact of compound interest in a negative way?
Articles and advice documents are full of figures and forecasts with suggestions on what to do and what not to do. Advice stipulates that investment portfolios must be created according to risk profiles, and rightly so. But what is the impact of just a 1% difference in returns over an extended period? More importantly, how much more do you need to invest over a very long period if you adopt an investment strategy that provides 1% less return per year over your investment lifespan?
Returns are equally important in retirement however, risk-adjusted returns are more important in retirement than pure racy returns that come with increased volatility.
A more muted return with lower levels of volatility will improve your probability of capital preservation when you draw income against your investments.
Planning around limiting volatility in retirement becomes your number 2 priority in investment planning once you are retired. Beating inflation remains your number 1 objective.
Volatility is your enemy when you draw income against your investment portfolio, but volatility is your friend while investing for maximum returns during your wealth accumulation phase…
Why do I make the above statement? Let me explain by way of examples.
Volatility in retirement. Where you start is of crucial importance, less so as time moves on…
Many self-professed financial professionals (of which some are do-it-yourself investors), advise placing all your investments in pure equity funds with a bias towards offshore shares. Since these investors are mainly fee sensitive, their strategy is to invest via ETFs (index trackers). This is not a bad strategy during your wealth accumulation phase, but what happens in retirement?
Have a look at the two graphs below.
I have kept it very simple and used the Satrix MSCI World Equity Index feeder fund (100% offshore exposure) which can be accessed via living annuities and the Satrix Balanced Index (restricted to 40% offshore exposure) as examples. I have not applied any blending of other funds, nor have I included actively managed funds to “massage” the results. I tried to keep it simple, fair and comparable. These funds are not a recommendation, they have been chosen to prove the point I am trying to make.
In the graphs, I assume retirement five years ago and retirement one year ago. In both scenarios, I assumed an investment amount of R5 million and a drawdown (income) of 5% per year. From the graphs the following conclusions can be derived:
Five years back the global Index fund was on a strong upward trend with a fairly realistic starting valuation.
One year ago, the global index fund was at an all-time high and considered expensive.
The balanced index fund was fairly priced over both periods and provided mediocre returns over both the five-year and one-year periods.
Both funds were clearly impacted in different ways by Covid-19 that started in 2020.
Investors who invested in the global index fund five years ago would today have a fund value of approximately R6.8 million after their drawing of 5% per year over the last five years compared to around R5.3 million value in the balanced fund. Both portfolios had a positive outcome with the global fund clipping the balanced fund by R1.5 million.
But what happens when the starting valuations are out of tilt like one year ago?
From the below graph we can conclude the following:
Over the past year, both portfolios would have experienced shrinkage due to the 5% income drawdown but the global index portfolio also experienced market losses as it re-priced to more realistic valuations.
Retirees who invested in the global index fund would today have a fund value of approximately R4.15 million (17% down) while investors in the balanced portfolio will have a fund value of approximately R4.75 million (5% down).
To break even the global fund will have to provide a return in the next year of 25.5% to get back to R5 million and pay 5% income, while the balanced portfolio will have to grow by 10.3% to get back to R5 million and pay the 5% income. If further losses are incurred during this year and next year the problem escalates and becomes a downward spiral that will make a recovery, especially of the global index fund, almost impossible.
Everyone should have offshore exposure however, the higher your drawdown is, the less offshore exposure you should have due to the increased volatility levels.
As I mentioned, volatility is your enemy in retirement.
I know that investing is a long-term game. However, people retire every day, and the starting price matters every day. The graphs are the actual experiences of investors who started their living annuities five years ago and the ones who retired one year ago.
The global figures look better than they should due to the rand depreciating over the last year by more than 9% and 28% over the last five years. The global index did much worse in USD than what the figures suggest. A weaker rand favours offshore investments priced in rands. If the rand was trading at fair value, the offshore index and related figures would have looked much worse. If the rand re-values to fair value the index will look worse.
There are different schools of thought of whether one should increase your equity exposure the higher your level of income or if one should reduce your equity exposure. One argument is that if conservative investment returns are lower than your income drawn then you have no chance of preserving capital and capital depletion is guaranteed, you must therefore increase equity exposure. The other argument is that due to increased volatility, capital can be depleted much quicker if disappointing returns and losses reoccur. Both views hold truth.
I believe that it all comes down to balance with exposure to all asset classes. In a higher interest rate environment, it does make it much easier to de-risk your portfolio with higher exposure to interest-linked investments while at the same time achieving decent returns.
As far as investing during your wealth accumulation phase is concerned, volatility is your friend.
The principle of rand cost averaging where you buy more units with the same rand amount during volatile times that lead to market retractions acts as a turbocharger to the compound interest principle.
Math’s time again
Let us assume you have 25 years to retire and you wish to accumulate an additional R15 million during this period. With no escalations and ignoring inflation, you will have to invest the following amounts in the different funds/sectors assuming that they will provide the same returns as they did over the past 15 years.
The above returns are the average returns of all funds in the respective sector, annualized over a 15-year period. These returns will be substantially higher through selective fund choice.
From the above, it becomes clear that it pays to accept more volatility. The additional funds that you need to apply to conservative investments to achieve the same outcome as more volatile investments are enormous. The difference between investing in cash versus for instance global equity amounts to R1 184 100 over the investment period. Add taxation to interest earned on cash and limited equity exposure funds and the figure becomes more pronounced. These funds should be applied to enhance your lifestyle and spoil yourself a bit more during your wealth creation phase…
