Investing is a deliberate approach to making the most of your money over a specific period of time.
Your investments should be balanced against your lifestyle needs – both present and future.
For example, if you have a life changing event in the short term such as a retirement then you should be investing far less aggressively than someone who is 35 who has just paid off all his debts and wants to save for the next 20 years.
Speculation is betting on returns. Particularly in a short space of time.
Here are three things to avoid which will keep you on a path of investing rather than one of speculation.
Using past performance to predict future returns
The big mistake is to take the historic returns of a fund over time and draw a straight line into the future. Returns are affected by many variables and
no one can predict these. If one could just imagine how easy it would be to make a lot of money. Economies and markets follow cycles and assets are affected by these swings over time.
Timing the market
Investing is all about compounding the returns achieved over time. Speculation is about trying to time the top and the bottom of the cycles of various markets. There is a lot of evidence using historic data that clearly shows that if you try and time the market you will get it wrong more times than right. Investors understand how markets move over the long term term maintaining the course through the ups and downs benefiting from the compounding along the way.
Borrowing to invest
Investors will be aware of their exposure to debt as the cost of borrowing neutralises the returns they get from investments. If you have a credit card debt of 20% and get a return from your unit trust of 15% then effectively you are negative 5%. Investors will deliberate over short, medium and long term objectives ensuring their exposure to debt reduces sooner than later. Speculators will ignore debt believing that they can outperform the cost of borrowing over any time horison.
Investors realise that it all about time in the market. Speculators will bet that the can achieve high rates of return without losing capital – especially in the short term.
There is value
The recent tax free savings account (TFSA) presents value for everyone by escaping the taxes which are levied on interest, rental income and capital gains tax. Depending on the funds that you invest in, this could reduce the return by a few percentage points. This makes a big difference in the compounding over time. So, there is a distinct value proposition found here.
Fees still apply
Don’t ignore the fees, however, as they still apply. You will pay fees to the administrator, the fund manager and the financial advisor (if you use one).
Depending on the funds chosen for the investment the collective fee could be as high as 2%. So, if the fund performs at 10% the actual return which will be 8%. If tax was applied this would be further reduced. This which is where the real value of the TFSA is found.
You can invest a maximum of R30 000 per annum (R2500 per month) with a maximum life time contribution of R500 000 which will take around around 17 years to reach. The ceiling will probably be adjusted over time to compensate for inflation as there is no provision for automatic inflation increases if you take up the maximum annual allowance.
The same investment principles apply
The investment is liquid, meaning that you can withdraw at any time. You should be careful, however, if you have a short term view. In which case, more cautious funds should be considered as opposed to funds invested in equities which need time to smooth out the risk of loosing capital.
You can invest online but do your homework and understand the T’s and C’s before signing up. Understand the funds and the relative costs along with the mechanics of investing and withdrawing.
In a highly taxed environment such as ours, any tax break on investments should be taken advantage of to improve your savings over time.
Reason 1 – Tax effective for high tax payers
Following last weeks topic on why you should not have an endowment it stands to reason that you will benefit from investing in an endowment if your tax rate is higher than 30%. The latest budget proposals have raised the top marginal tax rate to 41% which presents a benefit for taxpayers in this bracket benefiting even more when compared to a unit trust investment. What needs to be considered are the exemptions on the interest (R23 800) and capital gains tax (R30 000). If these will be taken up by other discretionary investments over the period of the endowment then the combined investment will be that more tax effective.
Reason 2 – Offshore Investments
The taxation applied to offshore investments is tricky and complicated. By wrapping your investment in an endowment policy you avoid the headache as the administrators are obliged to pay over the applicable taxes to SARS on your behalf.
Reason 3 – Payable outside the estate.
The endowment is a policy contract which allows for a nominated beneficiary. This enables the investment to be paid outside the estate in the event of the death of the owner. This is pretty useful in terms of providing much needed access to funds whilst the estate is being wound up. Furthermore, additional owners can be added to an endowment allowing the survivors to continue with it for as long as they wish instead of having to cash it in in the event of death.
It horses for courses when choosing an endowment. The main advantage is the tax benefits which tend to benefit the higher taxpayers.
Endowments are policy contracts which commit you to a minimum investment period of 5 years after which the proceeds are tax free. They basically provide a so called “wrapper” around various funds of choice which may be invested in various assets, such as, equities, property, bonds and cash. The returns from these assets (other than equities) are taxed inside the endowment at a flat rate of 30%.
Dividends from equities – 15%
Rental income from property – 30%
Interest from bonds – 30%
Interest from cash – 30%
REASON 1 – Tax rate lower than 30%
The first reason why you should not have an endowment is that if your tax rate is less than 30% you will more than you should to SARS. You would be better off investing in the same funds directly without the endowment wrapper.
REASON 2 – No cash fund in place
The restrictive period of 5 years ties your money up and if you need to access cash before hand then you could be penalised. A sound financial plan starts with cash fund which you can access for unforeseen expenses. The ideal balance in this account should cover your monthly expenses for between 3 to 6 months. If you don’t have access to enough cash for emergencies then you should have an endowment.
REASON 3 – Debt not under control
If you have high interest bearing debts such as credit cards, personal loans, overdrafts and mortgage bonds then these should be tackled before investing in an endowment. The returns after tax, costs and fees from the funds in the endowment are unlikely to achieve the same rate as your credit card, for example, 21%. Paying off your debt is a sure thing, without risk of losing capital, effectively providing a guaranteed return at the rate the interest is being charged. Therefore, the third reason you should not invest in an endowment is if your debt isn’t under control.