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January 28, 2014

“Double Whammies” – by Samuel Rossouw

“Double Whammies” – by Samuel Rossouw

blog-main-picWe all know what a “double whammy” feels like (referred to hereafter as a DW).  For example, it’s like when your bulldog bites you in the backside on the same day that your wife notifies you that she has found greener pastures, or when both your favourite sports teams loses (badly) on the same day.  It is an unpleasant, Prozac kinda moment, to say the least.In the financial planning arena, there are also a number of double whammies.  The only problem with these are that you often don’t see them coming until it is too late, and more often than not the damage is irreparable.  Let’s look at a few examples of these DW’s.  You will do well to avoid them.

DW 1: High fees and a conservative asset allocation

Regular readers of 2Cents know how often COSTS have been the topic of discussion.  Here we specifically refer to high administration costs that certain product providers charge.  The adverse impact of high costs have, however, become more obvious (especially on conservative investments) in the current low inflation environment.  Below is an excerpt of an actual case where a prospective client contributes to a retirement annuity fund.  The annual administration fee amounts to about 2% (based on fund value) and an initial fee of 4% is deducted from every contribution the client makes.
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To add insult to injury, 60% of this investment is allocated to a Money Market Fund, which is currently yielding only 4.36% p.a.


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This approach (conservative money market + high costs) means that the client’s funds returned an average of only 0.05% the past year.  In real terms, however, it means that the client’s purchasing power has declined by almost 6%!!  You should therefore be able to conclude that even if the interest rates increase considerably, this investor will never achieve a proper return on his hard-earned investment.

We are regularly bombarded with marketing material from insurance companies and product suppliers with so-called “new” or “improved” products, often with a promise of reduced costs as the bait.  In most cases these are not worth the paper they are printed on.  After working through all the smoke and mirrors, it becomes clear that the product remains extremely costly compared to a direct investment with an asset manager (like Investec or Allan Gray).  There is a difference between an average rate of return, the internal rate of return, return on underlying funds and the internal rate of return on the total investment.  At ProVérte we use the internal rate of return when we give feedback to clients regarding the performance of their investments; that is the return on your total investment account (not individual funds) taking into account all inflows (for example debit orders, additions, interest & dividends), as well as outflows (withdrawals, taxes, admin & adviser fees).  In our opinion it is the only accurate indicator of actual return earned and can be the only basis for long term planning.

DW2:  Aggressive investments coupled with a short-term outlook

Long term growth assets are accompanied by short-term volatility.  Accept it!  We simply do not have the ability to predict with any measure of certainty the short-term movements in markets or currencies, and I would also advise against listening to anyone who claims that they possess this gift/talent.  Short-term market rallies often create an unrealistic expectation with investors that it will continue forever, while temporary sharp declines are met with the same dose of irrational expectation that the decline is of a permanent nature.  To stay invested over a long term (without sabotaging your process due to greed or fear) is therefore more difficult in practice than in theory.

The following graph shows the return of the Satrix 40 Index (a proxy for the 40 largest companies on the Johannesburg Stock Exchange) for the last 13 years.  You can clearly see that the returns were not achieved in a smooth straight line and that there were considerable declines in prices from time to time.  According to the textbooks, you simply need to sit through market downturns like this and wait them out.  It sounds logical and simple enough, but the question is, how would you react or how have you reacted  during these episodes of “pain”.  Experience has shown that most investors simply cannot sit still and do nothing during periods like 2002 & 2008.  They feel compelled to act to protect the value of their investment!  Your emotions get the better of you and the way you react has a significant impact on your ultimate return.

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To illustrate, assume that you invested R 100 000 on 20/11/2001 in this investment.  Within 6 months (to 21/5/2002) your funds would have grown to R 126 000 (a return of 26% in only 6 months).  Your first thought would probably be, “What a great investment” (expectations are created that it would continue into perpetuity)!  At this stage you probably “brag” about your great investment around a “braai”, and 6 of your friends decide to follow suit and invest in the same investment.  Things start to go wrong soon after and the market starts to decline (reality becomes removed from expectations).  Except for the fact that your funds would have decreased to less than what you have ORIGINALLY invested, you would have had to wait for another 18 months just to get back to the R 100 000 that you started with.  Your now EX-friends would have had to wait almost 3 years just to get their initial investment back.  Once you get to this point, what is your next move?  Do you buy more, hold what you have or sell and run?  What sounded like an easy buy & hold strategy, now feels more like an opportunity to sell, since you would at least get the money back that you have invested.  If you, however, kept calm and stuck to the strategy, your fund value at 1/8/2013 would have been about R420 000 which, despite 2 market crashes, represents a respectable average return of 13% p.a.

The DW in this case would have been if you had panicked and withdrawn your funds in October 2003 or in November 2008 and decided to wait for 12 months, either to wait for the market to calm down, or until you felt confident enough to invest again.  In this scenario (if you parked your funds in a money market), your funds would have grown to only

R265 000, or an average return of 8.65% per year.  This is almost 33% less than the scenario above where you left your funds alone, BUT had to endure considerable volatility (and emotional discomfort).

DW3:  Money Market and Tax

We often find that when clients evaluate investment returns, they compare pre-tax numbers, simply because they are the figures that appear on their statements.  For example if you invest directly into a money market fund today, you would be quoted a return of about 5.5%, BUT, this is a pretax figure.  If someone has R 1 000 000 invested in an interest bearing account, and pays tax at a marginal tax rate of 35%, the additional tax liability (above the R 23 800 interest exemption for individuals) amounts to R 10 920 (in year 1).  The effective return  therefore reduces to 4.41% due to tax.  The table below shows the effect that tax has on investment returns.  Consider that actual inflation (i.e. the drag on your wealth) for most people is certainly not under 6%:

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The above returns are all coloured in red, since every single scenario of this investment gives a negative Real Return (in other words less than inflation). This brings me to the last DW.

DW4:  Too conservative investments and inflation

The graph below shows the return on a lump sum investment of R 100 made from 1 Aug 2003 until 31 July 2013 (10 Years) in the Absa Money Market Fund.  Your funds would have grown to about R 148.  If you  realised a return equal to inflation, your funds would have grown to R 131.  In real terms, you therefore achieved a positive return over this specific period and your purchasing power increased.

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After 2008 and a worldwide move to lower interest rates, the scenario have changed significantly.  The difference between money market rates and inflation is declining and, currently, a cash investment gives you a negative real return, even before tax and any withdrawals. The table below shows the real return over different periods.

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Note how the green bars (inflation) are creeping up slightly while the blue bars (interest rates) keep coming down, resulting in a negative “real” return (purple bars) currently.  It also seems like lower (negative) real cash returns are here to stay for the time being.  If you do not understand the impact of this DW on your wealth and make appropriate adjustments, it can derail your planning completely.  Appropriate asset allocation will greatly determine whether you reach your financial goals or not, and it is crucial to get this asset mix right.

How do you prevent financial “double whammies”?

  1. Be sensitive to costs, especially commission, adviser fees and administration fees. Make sure that you are comfortable with the advice or “service offering” that you receive from your financial adviser compared to what your are paying.  If you do not receive ongoing service or advice, then you shouldn’t be paying an ongoing fee.  Also make sure HOW you pay these fees.  Nobody provides “free” services or advice.
  2. Develop clearly defined long-term objectives and ask your adviser to put together a detailed and realistic plan about how to reach these goals. STICK to this plan and monitor your progress in co-operation with him/her.
  3. Understand the risk related to long-term negative real returns (funds that grow slower than inflation) and accept that short term fluctuations in the value of your investments cannot be avoided if you want to invest in assets that comfortably out-perform inflation over the medium to long term.
  4. Take income-, capital gains- and estate duty tax into consideration when you plan. Even though we will never really be free of tax, there are legal ways to reduce your tax liablity.

The end.

The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift. ~Albert Einstein

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.

Samuel Rossouw
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