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50 000 reasons to invest for the long term

20 May 2014 Dave Mohr, Old Mutual Wealth

When investing, there are some key concepts which should drive our thinking. The first is the importance of understanding which indicators are the ones we should be watching when making investment decisions – and which are simply just noise. The second is ensuring we’re taking full advantage of the power of compounding, diversification and spreading risk over time.

Is the 50000 level really that significant?

The FTSE/JSE All Share Index (widely known as the ALSI) came within a hair’s breadth of reaching 50 000 index points last week, despite the weak local economy. For some people, the 50 000 level is significant or "psychologically important” when in fact, it’s a rather meaningless number.
 
For others, the ALSI at around 50 000 points is a worrying sign that the market is completely overvalued since both the capital and total return indices are at record-high levels. An index is a very useful way of comparing historical performance, but an index level is not an indicator for when it is a good time to buy or sell. So the mere fact that the ALSI or S&P500 (or any other equity index) is at record-high levels tells us little. Equities will not have delivered long-term real returns in the order of 7-8% on average per year if the index did not regularly post record-high levels.
 
Valuation measures such as price: earnings (PE) ratios and dividend yields give us a better idea when it is a good time to buy or sell equities. Currently, the PE ratio – the price investors are willing to pay for the profits generated by companies - is around 17.8 and above the 30-year average of 14. The dividend yield of around 2.7% - in other words the dividend divided by the price – is in slightly below the 3% average of the last 30 years.
 
Compounding, diversification and spreading risk over time

In addition, when making investment decisions, it is important to understand the power of compounding, diversification and Rand cost averaging. To illustrate the power of compounding, the chart below compares the FTSE/JSE All Share Total Return Index and the ALSI over the past 30 years (both rebased to 100). While the FTSE/JSE All Share Total Return Index tracks exactly the same shares as the ALSI, with the same weights, its calculation includes the assumption that dividends are reinvested. (This is currently around 6295 index points, which is not an especially significant number.)
 
This chart illustrates that where investors reinvest dividends, a greater benefit from compound growth is derived. While there are ups and downs, over time this is a winning strategy.



Diversification is also important

Since different assets may behave differently under various market conditions, diversification is important. Historically, the JSE has delivered a real annual return of around 4% over a seven-year period when the starting PE ratio was between 16 and 18. Given an expected long-term inflation rate of 5-6%, long bond yields should deliver around 2-3% in real terms. Cash should more or less break even with expected inflation over time. SA equities can thus still be expected to outperform local bonds and cash. The latter two asset classes do however play an important role in a diversified portfolio.
 
Opportunity presents itself when we know where to look

It is also important to note that while the JSE All Share Index is an aggregate of all the companies listed on the JSE, it is dominated by a handful of large caps. So while looking at the index is useful for gauging the mood of the market, it hides a lot of information about the underlying sectors and shares.
 
Companies with close linkages to the local economy are generally cheaper than Rand-hedges. There are thus still a number of opportunities on the JSE. There are even more opportunities globally.
 
Spreading risk over time

Finally, investors should not ignore the power and simplicity of Rand cost averaging. Making regular investments - as one would do, for instance, through monthly pension fund contributions - means that when the market becomes more expensive, investors buy less. When the market dips, investors automatically buy more.

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