The journey to financial freedom starts and ends with saving and investing. A few ‘trust-fund babies’ and entrepreneurs apart, the only way to walk this path is to spend less than we earn and put the difference to work.
That applies to all salaried employees, even the uber-paid. A high income on its own does not guarantee a secure retirement. Sports Illustrated drove this home once when it reported that 78 percent of NFL football players and 60 percent of NBA basketball players (all on mega packages during their careers) suffered financial stress within five years of retiring. There are also plenty of tales about film and pop stars who ended up broke, and lotto winners now on the dole.
These celebrities didn’t just succumb to lavish lifestyles, many of them fell prey to elementary investment mistakes. The specifics may differ but the themes underlying these failures are as universal as they are avoidable.
Unfortunately, we are all susceptible to the same pitfalls. Even industry insiders, including some 10X staffers, have had to learn the hard way.
CASE STUDY 1: My RA: high fees, not enough risk
Chris: “Almost as soon as I started my first proper job, I took out an RA through PPS. The broker recommended a ‘medium risk’ portfolio and locked me into a 15% pa premium increase for the next 30 years, “to keep abreast of inflation”. The R1m illustrative nominal maturity value at age 55 seemed like a fortune at the time.
He made no mention of any early termination penalties and did not speak about fees (above 3% pa). Even if he had I probably would not have contextualised them, or considered how they would reduce my maturity value (by 26%). I also did not think about the purchasing power of R1m in 2018 and how investing in a medium rather than a high equity portfolio would diminish my long-term return.”
Like many other uninformed investors, Chris was duped into buying an inflexible, high cost, low return savings product. It would barely pay back his premiums one day, adjusted for inflation, but not build any real wealth. Projecting the maturity value in nominal rather than inflation-adjusted terms created a false sense of future wealth.
Today’s young investors are in a much a better position to avoid making the same mistakes. There’s a wealth of financial education online. They are also not limited to life insurance Retirement Annuities (RAs), subject to compulsory (and often conflicted) “financial advice”. Many asset managers now sell RAs direct to the public at a much lower cost on flexible terms and without punitive early termination penalties.
Unfortunately, the traditional RA industry has not reformed. As Chris recalls: “A few years back, another PPS consultant tried to sell me a second RA, and the fees were as high as they were in 1990. I declined, but uninformed investors will still get caught out.”
CASE STUDY 2: My provident fund: underperforming active managers, high fees, competing strategies
Kim: “My previous employer offered a provident fund. This was a brilliant benefit, with a mandatory 15% contribution rate paid by the employer, both on salary and bonuses.
Less brilliant, with hindsight, was that we could allocate our money across a range of fund managers. They all reported their returns separately, before fees, against their individual benchmarks. I had no idea how my portfolio performed overall and what fees were being deducted. By spreading the money across different funds, with neutralising strategies, I was at best matching the average market return but at high cost.
The bigger problem was that, along with my colleagues, I did not really pay attention. We did not question the poor disclosure and variable returns amongst our funds. We accepted the element of luck in choosing a manager, and the inevitability of high fees.”
The indexing revolution has been an enormous boon for investors, and not just because it exposed the poor results delivered by the majority of fund managers. It also changed the conversation from picking fund managers to optimal asset mix and fees. It’s these two factors that overwhelmingly determine the investor’s long-term return. Because indexing is a low-cost strategy that avoids manager selection risk, it delivers a superior outcome for most investors.
“For the last decade, my provident fund savings have been invested in a low-cost index fund. My return has been above average but, more importantly, I have saved an absolute fortune in fees along the way,” says Kim.
CASE STUDY 3: My discretionary savings: inadequate diversification, discipline
Richard: “My discretionary portfolio includes a few of my favourite shares, very much ‘buy and hold’ stocks with a solid, long-term growth record and decent dividend yields. Although I spread my money across industries, countries and currencies, it proved to be insufficiently diversified. The collapse of the MTN share price last year left its mark.
I also own some preference shares, which initially delivered a tax-free cash flow until the government started taxing dividends, which impaired both their income and capital value.
I am a latent market timer so I have not been disciplined in reinvesting my dividends. My portfolio value has grown decently over the years, but nowhere near what it would have done, had I simply earned the average market return.”
Buying individual shares is a mug’s game. The chances that you’ll load up on Naspers share at R40 and hold on all the way to R4, 000 are slim; the risk that one or more of your stocks bomb is enormous.
Certainly, as far as your serious money is concerned, the lesson is to avoid stock-specific risk and invest in market-tracking index funds instead. Even the smartest professionals cannot reliably beat the market, so there is no reasonable hope for hobby investors trying this at home.
CASE STUDY 4: My pension fund: failing to preserve
Declan: “On leaving my former employer at age 29, I did not preserve my retirement fund. Instead I cashed out and bought a car. What I didn’t consider was that this would not only cost me my savings, but also the return thereon for the next 40 years or so. The money would have grown six or seven-fold by then, in real (after-inflation terms). Cashing out early not only takes a big chunk out of my retirement income but also makes for a very expensive car.”
According to various industry surveys, between 70 percent and 80 percent of employees don’t preserve their savings when they change jobs. Younger employees, especially, are full of hubris that they have time to make this up. They don’t appreciate the long-term value of those early savings. For example, in the context of a diligent 40-year saving plan, the first two years’ contributions already fund 10% of your pension. It’s not so easy to catch up by saving more later.
The sensible option when you change jobs is to transfer your savings tax-free to your new employer’s fund or to a preservation or RA fund. This preserves not just your savings and attached tax benefits, but also keeps your money growing until you do claim.
Getting it right: avoiding the Big 5 unrewarded risks
According to various surveys, our single biggest regret at retirement is that we didn’t save more. Fortunately, that risk is under our control.
But investing also invites regret. Wherever we put our money, there is always another stock, another portfolio or another strategy that we could be choosing. Some regrets are avoidable, though, namely those that relate to taking on unrewarded risks. Most of us are guilty of this at one time or another. These mistakes usually won’t ruin you, but they probably will leave you much worse off than you could have been:
1. Inadequate diversification (over-exposing your money to individual investments);
2. Being too conservative in your asset mix (long-term investors putting too much money into defensive, low growth assets);
3. Market timing (deciding when to move money in and out of cash);
4. Manager selection (investing with fund managers who underperform);
5. Over-paying on fees (more than 1% pa).
Fortunately, it’s possible to exclude all these risks simply by investing in a broadly-diversified, low cost, equity index fund and holding on for the long-term. That’s Warren Buffett’s “best advice” to investors, and that‘s the instruction he famously included in his will for the benefit of his wife. And if it’s good enough for Mrs Buffett then it’s probably good enough for everyone else too.