Market volatility and your portfolio – staying the course

There seems to be no end in sight to the current global financial crisis and there are many factors which are causing the extreme movements in the market – too many to mention. Every day investors are bombarded with doom and gloom in the newspapers and o

There seems to be no end in sight to the current global financial crisis and there are many factors which are causing the extreme movements in the market – too many to mention. Every day investors are bombarded with doom and gloom in the newspapers and on TV, resulting in confusion and panic. For those who are already retired, permanent capital loss is a very real concern.

One should always bear in mind that markets move in cycles and the golden rule is always to stick to your financial plan and to make rational, considered decisions, rather than emotional ones. People are living longer and it’s possible that if a person retires at age 60, they may live for another 25 – 30 years. When seen in this light, it is advisable to view one’s retirement savings as a long-term investment and to ensure that there is a certain allocation to growth assets such as equities to ensure growth above inflation.

Investors, understandably, focus on the risk of capital loss – but in the process, they often also overlook the fact that their savings need to outpace inflation for the duration of their retirement so that they can sustain their income level. This can only be achieved by holding inflation-beating assets in your portfolio. History shows us that equities have been the best-performing asset class (as well as the best inflation-beating asset) over the last 100 years. Although short-term performance can be volatile, returns from equities do smooth out over the longer term to provide investors with solid, inflation-beating returns. This can be seen from the graph below which shows returns from the JSE All Share (excluding dividends) from 1960. Looking back, one can see that dips in the market don’t last forever and that those who stay invested during this time are rewarded with higher returns as the market recovers.

Source: I-Net

Retired persons with a conservative risk profile should consider taking on a limited amount of risk in order to at least give themselves a chance to maintain their lifestyle into the future. Asset allocation and stock selection also have a role to play. Skilled asset managers with a mandate to move between asset classes as the market moves can protect capital over the short term while still managing to beat inflation over the medium to long term.

Remember also, that retirement is not a destination, it is a journey and as with all journeys, one needs one’s cash to last the distance. Investors may think they’re reducing risk by moving all their savings into cash (or cash-like instruments), but in fact they could be introducing an even bigger risk – that of not being able to realise inflation-beating returns, leading to capital depletion. Market commentators expect the next decade to provide much lower returns than South African investors have become accustomed to over the previous decade. This further increases the need to take on that extra bit of considered risk.

Although investors may feel uncomfortable with the introduction of a limited amount of risky assets in their portfolio, it’s important to point out that currently, the repo rate is at a 37-year low. This rate is directly related to what you’ll earn in cash or a money market investment. The expectation is that interest rates will remain low for quite some time, resulting in a negative real return.

As a starting point in compiling your investment strategy, you’ll need to determine your capital need, risk profile and income requirements. If there is a shortfall, and you’re unable to reduce your income requirements, you may need to become a slightly more aggressive investor. It’s important that you balance your willingness to take risk with your ability to do so. A qualified financial intermediary will be able to guide you through this process.

If you’re currently invested in a conservative portfolio, you may consider a cautious or even a moderate portfolio.

The conservative investor requires stable investment growth or a regular, stable income. The primary investment goal is therefore capital protection, or immediate access to income. This investor may require access to the investment within three years or less.

By definition, a cautious investor requires stable growth in the investment and is uncomfortable when investment values decline. A cautious investor invests for at least three years and the primary investment goal is capital protection. The moderate investor, on the other hand, invests for the slightly longer term (at least five years). The primary investment goal is capital growth and the investor can tolerate fluctuations in the value of the investments.

Let’s look at some of the options.

Income – Nominal versus real

The tables below show the income you can expect to receive (Rand amounts) in year 1, year 10 and year 20 – for each investment return (dependent on risk profile) and selected annual income rate. We’ve assumed a capital investment of R1 million, a future inflation rate of 7% and intermediary fees of 0.5%.

The first table shows nominal income, i.e. the actual income you will receive, allowing for inflation of 7%.

The second table shows real income, i.e. the buying-power that your actual (or nominal) income will have 10 and 20 years into the future.

( Click on images to enlarge)

One can see, when looking at the real income table, that actual buying power will only increase if you are invested in at least a moderate portfolio and drawing a very low annual income.

Capital value – Nominal versus real

The tables below look at the combined effect of investment return and annual income rate on your capital value (Rand amount) in year 1, year 10 and year 20. We’ve assumed a starting value of R1 million.

Once again, the first table shows the nominal, or actual, value of your capital, assuming a 7% inflation rate.

The second table shows real capital value, i.e. the buying power that your capital will have.
(Click on images to enlarge)

Looking at the capital values in the nominal table, it is evident that the lump sum values will increase if your income is less than the inflation assumption. However, the real enemy over the long term remains inflation. Although your capital amount will be increasing, it is still sobering to look at the purchasing power of your capital in the table showing the real value.

With increased equity exposure comes increased risk. But it is clear that a combination of enhancing returns (by adding more risk) and being prudent when choosing an income drawdown rate will give you a much better chance of maintaining the buying power of your capital. So start with what you hope for today – and speak to your financial adviser to ensure a carefree, successful retirement.

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All figures provided by Glacier ICE.