A Beginners' Guide to Investing for Retirement
Investing and planning for retirement is something which doesn’t come naturally to many of us. By virtue of your membership to the ISASA Pension Scheme and Provident Fund, you are already on your way to investing for your future. Every month, you and your Employer make contributions to the Fund that is saved towards your retirement.
These monthly contributions are then invested either as per your School’s selected strategy, or in accordance with your own instructions. Each investment strategy has one or more underlying investment portfolio.
Investing for retirement is a long-term process and can be daunting if you do not understand how these investment portfolios are constructed (put together) within the parameters set out by law. This note covers some basic investment principles. Understanding these principles will go a long way in making informed decisions about your investments.
What is a portfolio?
An investment portfolio is a combination of different types of asset classes. As can be seen from the above example a portfolio can have portions invested in various asset classes or investments such as shares, bonds and cash.
|Type of Asset||Description|
|Shares||You are part owner of a company. This is the most risky investment as you can lose a portion of your investment if one of the companies underperforms. An investment in shares should provide you with high returns over the long term but your investments will be affected by short term market fluctuations.|
|Bonds||These are loans to the government and other large semi-government organisations. These are less risky than shares.|
|Cash||This is the safest investment type, except for the risk that the returns may not keep up with inflation over the long term.|
Principle 1: Retirement investments are long term
Statistics show that people live a lot longer now than they did in the past. If we view the above timeline we note that most people retire between the ages of 60 to 63, leaving only 40 to 45 years of formal employment in which to save for retirement.
The trustees of a retirement fund have to assume that members will stay with the company and be members of the fund for the long term. They have to take this long-term horizon (40 years) into consideration when designing their investment strategies. In general terms, trustees aspire to design portfolios that beat inflation by significant margins over the long term. This necessitates creating portfolios that carry with them a degree of risk. As we will see later on in this document you need to take risk in order to achieve investment growth.
What is asset allocation?
Asset allocation involves dividing an investment portfolio among the different asset types, such as shares, bonds, and cash. The process of determining which mix of assets to hold in a portfolio, is made by the investment manager.
The asset allocation that works best for you at any given point in your life will depend largely on your time horizon to retirement and your ability to tolerate investment risk.
- Time Horizon - Your time horizon is the expected period (number of months, years, or decades) you will be investing until you reach your normal retirement date. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of the markets. When retirement fund portfolios are constructed, they are done on the basis that members will usually have a long period to invest (their time horizon) until they reach retirement. There are special portfolios that are designed to protect member’s assets when they are close to retirement. We will discuss these later.
- Risk Tolerance - Risk tolerance is your ability and willingness to experience both positive and negative returns on your investments. An aggressive investor, or one with a high-risk tolerance, is more likely to risk negative returns over the short term in order to get better results over the long term. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment and provide very little negative returns over time (although the returns will also be lower).
Investment principle 2: Shares outperform the other asset classes over time
For periods longer than 10 years, the local equity market has never recorded a negative return. History has shown that in the long run the equity market rewards an investor with inflation beating returns, but to be able to reap the rewards the investor must be able to tolerate short-term volatility.
If we consider the graph below, it shows the value of R100 invested in shares, bonds and inflation. Bear in mind that the cash returns will be more or less in line with inflation over time. The red line shows that the R100 invested in shares has grown to almost R700 in 10 years, the R100 invested in bonds (blue line) has grown to R400 over the same period while inflation would have taken the R100 to approximately R180.
When one considers the same R100 invested over an even longer period in this case 80 years, the outcome is much the same in that shares provide the best long term return than the other types of asset classes.
It is for this reason, that the trustees of the Fund offer portfolios with a high equity (share) content especially for younger members who still have a long time horizon (time to retirement) and who are able to take on additional investment risk. However, it is important to note that currently legislation requires that a maximum of 75% of a retirement fund investment portfolio can be invested in equities (shares) whilst the remaining 25% must be invested in fixed interest instruments, bonds and cash.
You can see from the graphs that over the long term (10 years or more), it is not favourable to invest only in fixed interest, bonds and cash because these investments do not provide the returns that shares do, although, over the shorter periods, the returns from these portfolios are not as volatile as shares.
Principle 3: There is no reward without risk
When it comes to investing, risk and reward are very closely linked. You've probably heard the phrase "no pain, no gain" - those words come close to summing up the relationship between risk and reward. Don't let anyone tell you otherwise: All investments involve some degree of risk. Over the long term even cash has an element of risk because the returns of a cash portfolio may be below inflation which means that the purchasing power (how much you can buy with your money) is going down.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like shares or bonds, rather than restricting your investments to assets with less risk, like cash equivalents.
Principle 4: Diversification is key
Diversification is a strategy that can be best described as "Don't put all your eggs in one basket." The strategy involves spreading your money among various investments (shares, bonds and cash) in the hope that if one investment loses money, the other investments will more than make up for those losses.
The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification.
By including different asset classes with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset classes (shares, bonds and cash) have not moved up and down at exactly the same time. Market conditions that cause one asset class to do well often cause another asset class to have average or poor returns. By investing in more than one asset class, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset class's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.
In addition, asset allocation is important because it has major impact on whether you will meet your financial goal at retirement. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal.
Some financial experts believe that determining your asset allocation (by selecting the appropriate investment portfolio) is the most important decision that you'll make with respect to your investments. With that in mind, you may want to consider asking a financial professional to help you determine whether your investment portfolio is appropriate for you, given your personal circumstances, additional investments (if any) and so on.
So why are we telling you this?
It is important that you understand the reasons behind the construction of the various investment portfolios offered by Fund. Those portfolios with a higher allocation to shares (as opposed to bonds and cash that make up the rest of the portfolio) are typically there for younger members or members with a long time horizon who want to maximise their long term returns and take on slightly higher risk. Similarly, the portfolios that have fewer shares in them, with a higher exposure to bonds and cash are typically for members who are closer to retirement and have a shorter time horizon.
Once you understand the reasons behind how the portfolios are constructed, you need to make sure that you are on track as far as saving for your retirement is concerned and ask yourself the question: Will I achieve my retirement goals?
As mentioned earlier in this communication, you may need to approach a professional financial adviser to assist you in this regard and formulate an appropriate investment strategy.
Remember with adequate planning, preparation and enough information it is possible that you can retire with peace of mind, realising your hopes and dreams for the future.