TAX FREE SAVINGS ACCOUNT
South Africans can now invest in tax free savings accounts (TFSA). These simple and easy-to-understand products were introduced last year. They offer full disclosure on fees and have no penalties on cash-out. These are great for all of us and will hopefully create a culture of savings and attract first-time investors.
The TFSA can house different investment types, from guaranteed and secure bank deposits to unit trust and exchange traded funds holding equities.
In this article we set out the rationale for starting to invest and despite the volatility of stock-markets and the uncertain economic outlook, to include an allocation to equities.
Some advisers may suggest that high-tax payers should use the TFSA to house their interest-bearing investments (including property) only. The logic being that these investments, with high-income rates, benefit the most from the tax-free status. For long-term investors however, the benefits of tax-free status can be as compelling for general equities.
Many of us may feel that current times are too uncertain or too volatile to make an investment into equities, but lessons from history suggest that we should not delay and we can reduce – but not eliminate – risk in an equity-based investment in two ways:
Regular contributions over a full investment lifetime
We need to commit to making regular investment contributions throughout our investment lifetime. It’s a simple principle but it’s not easy to stick to this plan. Almost on a daily basis, we are bombarded with news about the local and global economies. We have seen how stock markets can move fairly sharply up – like they have in March - and down – like they did in December and January - within a few days.
The challenge is to not let this derail us from our savings plan. But for many of us it does. We either don’t start to save or we stop making contributions - or worst of all we sell and cash-out our investments. Many of us then wait until we feel the investment environment is more favourable. This is a bad investment process because no-one can consistently time when to get into or out of investment markets and when we try, we generally get it wrong by buying when investment values are high and selling when investment values are low.
As Dr Burton Malkiel (world renowned Professor of Economics and Senior Economist at Princeton University) has indicated, “a policy of staying the course and steadily putting new savings into your portfolio (no matter how uncertain the outlook), is the time tested and surest method to accumulate wealth”.
Making regular investment contributions, leads to what is referred to as ‘Rand-cost averaging’. What this means, is that we invest the same fixed amount each month, and although investment markets will be high sometimes and sometimes low, the regular contributions averages this out and reduces the risk that our entire investment is made at temporary inflated prices.
Let’s look at an example through the turmoil of the global financial crisis in 2008-2009 when our local stock market (JSE All Share Index) fell 40% - from May 2008 till Feb 2009.
In the chart below we show the percentage gain/loss for two types of investors starting to invest in May 2008. The first investor makes a single investment and the second investor makes regular monthly investments.
A single investment at end of May 2008 would have fallen 40% by end Feb 2009 and would have taken until October 2010 to fully recover this loss – provided the investor had remained invested during this time.
The situation would have been far less brutal for a regular contributing investor. The investment value would have fallen 20% by end Feb 2009 and would have fully recovered the loss by July 2009. The power of compounding is most powerful over long periods of time. At end Feb 2016, the investment would be worth nearly 70% more than total contributions – an annual return of 14%. So despite starting to invest just before the 2008-2009 crash, the investment would have weathered the storm.
It is important to note that Rand-cost averaging is not optimal if markets go straight up. In this scenario you should put all your investment in at once. But future returns are uncertain and no-one can predict when to get into and out of investments so Rand-cost averaging provides reasonable protection again poor future performance.
Keep Costs Down
There is an ongoing debate within the investment industry. Do you choose indexed (passive) investing or active investing? Indexed investing seeks to replicate a basket of shares, such as the 40 largest shares on the JSE. So you don't pick which shares to buy - you buy all the shares specified in the basket (called an index). The alternative is called active investing where the investment manager picks certain shares and steers clear of others.
The investment results are counter-intuitive. Typically, only around 30% (or less) of active managers beat a low-cost index fund after accounting for costs. This is the case in South Africa and around the world.
The key reason for this is costs. Before costs, the indexed investor gets the aggregate return of the basket of shares because it buys the basket. In theory, half the active managers will beat this aggregate return and half will fall short. It’s a zero sum game. But that is before costs. After costs indexed beats a lot more than half the active managers because active managers’ fees are much more than indexed fees.
Earlier this month, the Oracle of Omaha, the great Warren Buffet, offered some investment advice to basketball superstar Le Bron James. This is the same advice he has been offering for years; make monthly contributions over your full investment time period – 30 or 40 years – into a low cost equity index fund.
Keep it simple. Take advantage of the TFSA structure and select a low-cost investment fund. If you are a long-term investor, include an allocation to equities and make regular contributions. And stick to this plan. Start now, so the power of compounding of returns begins working for you today.
Written by DAVID SHOCHOT
CEO - STYLO INVESTMENTS