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I spent last weekend in a nice little house next to the ocean with an old friend I hadn't seen for ages and he and I spent the weekend debating the world, our futures in it and inevitably the subject revolved around investing and the whole FIRE debate about the associated risks of retiring early.
Of course I was the staunch defender of why getting off the hamster wheel as early as possible in life is simply a brilliant idea and that most of the risks are drilled into us by our parents (who want the best for us), employers ( who need our skills and don't want us to leave) and the government (who want the taxes from our hard work). As a hugely successful individual in his own right with a high powered corporate job, my friend was paying the devil to my angel and giving me a good old grilling whilst looking for the gaps in my thought process in order to shoot holes in my theory. This sparring went on throughout the weekend with small gaps for eating, drinking (it was the weekend), sleeping and staring aimlessly at the ocean!
I'm not sure I convinced him but it did give me a bit of a realisation on a few things.
The first and probably most important was that people have very different views and understanding on risk when it comes to where to store your savings and / or investments. The second was that there is an absolutely massive difference between your understanding and trust of something, versus whether it is actually a risky investment or not. And then the final realization was that asset classes (what you invest in e.g. stock market, property, gold etc.) have shifted in fairly recent times and are certainly different for me having moved across the world to South Africa from the UK, where how much money you can make in an asset class is very different between the two countries. A quick example being that in the UK a bond ETF might get you 1-2% annual return where in South Africa, that same bond ETF might pay 7-9%.
I've been reflecting on our conversation since I got back home yesterday and it got me to thinking how much wealthier most people could be with just a little more thought about risk and time when it comes to theirs savings and investments. It gave me a picture in my head that I felt like I wanted to share. If you're a seasoned investor, you're probably not going to get much out of this (although I'd love you to provide your thoughts in the comments), but if you're a bit like I was when I started my journey as more of a willing participant who wants to get his money working as hard as possible for your future, then this is definitely worth a read.....I hope!
So, let me try and explain my thinking.
Let's say Bob has been working hard for a couple of decades no and is in his mid-thirties. He's saved just as hard and has a pretty good job which he enjoys, his lifestyle for him and his family (ha s has a wife Beth and a 5 year old daughter called Molly) is good but not exuberant and he has been saving 10-15% of his salary for the last 10 years to provide for his future and he'd like to retire comfortably and not work late into his twilight years.
It doesn't really matter how much Bob has saved or how much he earns but let's assume the sake of simplicity he's managed to save R1,000,000 /$66,600 / £50,000. This is currently sitting in his everyday savings account in South Africa getting him around 2.5% interest paid monthly.
So let's do a quick analysis of Bob's situation:
Age - He's 35 and currently plans to retire at the "Normal age of 65" he gets a company pension so the basics are taken care of but he plans to invest his savings until retirement at 65. This means he has a 30 year timeline for investment
Emergency Fund - Bob drives a company car and works for a big organisation, he's been with them 10 years and he's well liked and the company has been doing well and is 100 years old. His job is more safe than most. His daughter will go off to college/university in around 12 years so Bob will need some money to help her with that. Other than his savings, he has nothing put aside for unexpected costs.
Family - Bob's wife Beth doesn't work as she's bringing up Molly but she was previously an accountant and had a good salary. She doesn't plan to go back to work right now but could if she had to and will probably look to re-enter the job market when Molly goes off to high school in around 7 years
Home - Bob has a bond/mortgage which is up to date and he has equity in his home already but not a great deal. The mortgage still has 10 years to run and the interest rate is 8%. the house is worth R2.5m / $166k / £125k and there is still around R1m / $66k / £50k owing.
Expenses / Debt - The family as relatively low debt, other than the bond there are credit cards which Bob pays in full each month and Beth has a small car to take Beth to school and run errands which is financed and has 1 year left to pay. The car loan has an interest rate of 12% and there is R50,000 / $3,333 / £2,500 left owing.
Ok, so Bob is in a pretty good situation and I guess is typical of a young middle class family who is just about hitting financial stability having paid off student loans, made a hole in the mortgage, bought all the big essentials of normal life and paid off the credit card debts from their youth. They're doing pretty great.
So let's talk about risk and how Bob might want to think as an investor. And to keep a tally let's use an index system that ranges from -100 to 100. Let's say you start at 0 and deduct points for risks and add points for opportunities. The final score will define if Bob can take more risk or should pull back on his lifestyle.
Ok so here it is:
Bob has a good job he's been at a long time and it clearly pays pretty well. The company car is a big win and shows he must be fairly senior. However, in the current environment of COVID-19 and the need for companies to cut costs to survive there's no such thing a safe job so lets deduct 10 points right there for that. Let's also deduct another ten points because Bob has a company car, no job = no car and an unexpected expense.
Current score -80
Beth had a great job and gave it up to bring up Molly but she has skills. If things got tough she could start a side-hustle doing people's tax returns or get a part time accounting job or even go full time and pay for childcare for Molly. Lets add 25 pints based on Beth's earning potential
Current score +5
The house is worth significantly more than what is owed now so if things went pear shaped, Bob and Beth could sell the house, downsize or leverage their equity to keep them afloat. Let's add 15 points for the positive equity in the house
Current score +20
Molly is just 5 so has passed the expansive baby stage and is some way off the expensive college stage. She is still all little young so incurs a child care cost but in a few years she'll get to be relatively low cost (you can say no to the pets) and then there will be not much major investment until she goes to high school and needs all of the stuff that goes with that. let's add 20 points for the fact Molly isn't going to cost significantly more than today for probably 7 years.
Current Score +40
Whilst Bob has some savings, there is nothing put aside for emergencies which is a bit of an issue. It doesn't need to be a fortune but having nothing could mean that those credit cards don't get paid off and start incurring debt an interest. Lets deduct 10 points for emergencies and credit cards.
Current Score +30
Bob has been moderately successful to date and if he keeps his job until the pandemic is over he may be able to get further promotions and if Beth does go back to accountancy that would be another good salary coming in so lets add 25 points for future potential earnings.
Current Score +55
Bob and Beth are both still 35 and aspire to retire at 65 or earlier. They already have a retirement savings vehicle so their future pension is somewhat taken care of if nothing goes wrong. Let's add 10 points for having a retirement plan.
Final score +75 - Outcome - Bob & Beth's financial situation is very low risk.
This is obviously simplified but it is a good way to do a quick risk assessment of your situation and if you're honest and realistic about your thought process you'll quickly get to see how much risk you can afford to consider in your savings and investments.
Ok, so if I was Bob and I had done this assessment, I would be willing to take a fair amount of risk with my savings after I'd taken care of the emergency fund. bearing in mind I'm not Bob and I have a naturally high tolerance for risk, take this with a pinch of salt!
Firstlly, I would immediately pay off the remaining R50,000 / $3,333 / £2500 on Beth's car. Simply because it carries a 12% interest rate and represents one of the household bills. Paying it off not only saves the interest, it reduces the amount of money needed every month if Bob loses his job.
I wouldn't do anything with the bond/mortgage at 8% interest and I'll explain why in a moment.
Next I would create an emergency fund of R50,000 / $3,333 / £2500 in an instant access high interest savings account so that if any unexpected bills come up I instantly have a cash pile outside of my investments to draw upon. A quick Google tells me that First National Bank have such an account providing an interest rate of 7.8%. Where do I sign?
Next is the most important and debatable part. The remaining R900,000 / $60,000 / £45,000 and where to put it. this is where we'll also address why I wouldn't pay off the mortgage / bond.
This is probably the most important part of this post if you live in South Africa. We are very fortunate in our country that if you have money to invest you can invest in South African Bonds for a return of between 7-9%. Let's call it 8% as an average. You can also buy these bonds as ETFs which have low fees and can be bought and sold like shares. This means you can get an 8% return and still have access to your money within less than 5 days. Bond funds are low risk, they do not fluctuate hugely like interest rates can and there's lots of them about.
It is for this reason that a bond ETF is lower risk than paying off a chunk of your mortgage if your mortgage interest rate is 8% or lower. Because if you pay the mortgage and something goes wrong it's difficult to leverage your mortgage to release cash and is definitely going to take more than a few days, whereas you can liquidate a bond and have cash in less than five (only depends on the speed of your provider).
So lets put 20% of Bobs cash into an SA bond and my current favourite is the Sygnia All Bond Index Fund which currently has zero fees until the end of 2022 and has delivered 8.3% annual return over the last 5 years. It's not actually an ETF, it's a Unit Trust (basically the same thing but not tradeable on the stock market) so the easiest way to get it is to open an account with Sygnia which you can do online.
So all we've done so far is reduce Bob's risk further by giving him an emergency fund, paying off the car and giving him a low risk bond fund.
Time to spice things up a bit.
One of the big risks we haven't talked about yet si the good old South African Rand. It's relatively strong right now but as the economy is so weak and huge amounts of alleged government corruption is currently being investigated, the future may be bleak for the Rand against the Dollar, Pound or Euro. Because of that, I'm going to reduce Bob's risk further and we'll open him an EasyEquities account so he can get access to the US stock market. This means if the Rand weakens, Bob's offshore investments will actually increase in Rand value.
So a quick scan of EasyEquities and I've picked 3 ETF's for Bob to invest his remaining R720,000 / $48,000 / £36,000 in:
R200,000 / $13,300 / £10,000 - Vanguard S&P 500 ETF - My personal favourite, tiny fees, low to medium risk (in my opinion) and should give bob around a 12% return annually
100,000 / $6,600 / £5,000 - Ark Innovation Fund - A tech based fund which invests in emerging technologies. Tesla was an early member of this ETF and it has delivered an average of a 36% return on the last 7 years. this one is high risk so I've kept the investment low
R200,000 / $13,300 / £10,000 - Vanguard Mega Cap Growth - This ETF includes the top companies in the world including Apple, Google, Netflix, Facebook, Microsoft, Amazon and Tesla so should provide a solid return around 16% at a medium risk
R220,000/ $14,600 / £11,000 - Vanguard Total Stock Market - Probably the broadest passive index ETf you can buy, this covers the entire world so whatever happens and whoever comes out on top in the next 35 years, Bob will have a piece of it! This is a low to medium risk play which should pay around 12% annually over its lifetime.
And that's it. Bob can sit back and stack leopards (the south african version of Benjamins!).
Because it's all of Bob's savings he will now have a balanced portfolio with global exposure as well as a high risk investment that over time could make him a wealthy man and 20% investment in bonds in case there is a market crash (for him to pick up some bargains or if he has an unexpected life event). If I had to put a risk score on this portfolio I would go with low to medium which on our little index would probably be around the +50 mark. if you remember, Bob was at +75 so could afford to take a bit more risk. When Beth decides to go back to work,. the pandemic disappears or Molly grows up and moves out, all of these things will be opportunities for Bob to dial up his risk further, but right now, I estimate he'll make about a 10-12% return without the chance of him losing significantly if things go bad and certainly I would say there is close to zero risk of a bad return (less than inflation) over 35 years. That is a lot better than the 2.5% he's getting right now in his savings account.
As always this is not financial advice and you should seek professional help if you intend to invest savings you can't afford to lose, but hopefully this helps someone who has their savings sitting somewhere getting less than an 8% return. I hope i've explained enough for you to see that you can have 8% with a risk index score of 100% (no risk) so anyone who is paying you less is probably putting your money there and taking a cut. Equally you can get as much as 12% with low to medium risk and the longer it's invested, the lower that risk becomes.
Until next time, keep living