Hoping for the best is not an investment strategy

By Elmie de Jager

1/7/2023

It is unlikely that any pilot will undertake long and demanding flights without going through a meticulous process. Before embarking on their journey, pilots determine the distance to be covered, ascertain the necessary fuel quantity, assess the prevailing weather conditions, and conduct thorough pre-flight inspections.

It’s astonishing to see how many individuals adopt an entirely different approach when it comes to creating wealth or planning for retirement. They simply hop on board as passengers and hope for the best outcome.

While this approach is possible, it requires absolute confidence in your pilot.

If you happen to be the pilot yourself, receiving proper flight training is crucial.

Regardless of how you approach your “flight”, it is advisable to steer clear of these common mistakes that we frequently observe in practice.

Read your instrument panel

It is as nonsensical to be unaware of the status and condition of your aircraft as it is to be oblivious to the returns on your investments and how they compare to the circumstances under which they were attained.

The Internal Rate of Return (IRR) serves as a crucial measurement tool in investments, providing valuable insights into relative performance, including the influence of personal behaviours like fear and greed on investment decisions.

I would like to highlight two areas where clients tend to overlook the significance of this important instrument:

Direct equity portfolios:

With the exception of those held on a LISP administrative platform, personal share portfolios typically lack IRR calculations. As a result, clients remain unaware of their portfolio’s performance and how it compares to a competitive strategy, such as an equity unit trust, over time.

Neglecting to assess this instrument is a significant oversight, as even a small deviation of a few percentage points (comparable to being a few degrees off course) can lead to disastrous consequences.

Take immediate action to rectify this oversight by requesting your stockbroker or financial advisor to provide you with an IRR calculation for your portfolio. Compare this calculation to a relevant benchmark, such as the JSE ALSI Total Return for local equities or MSCI World Index for foreign equities.

In addition to assessing relative performance, it is crucial to examine an absolute growth target, such as inflation plus 5%, and ascertain whether it aligns with the returns necessary to reach your financial goals.

Insurance-based investments/contractual investment plans:

Even more so than with direct equity portfolios, I have never encountered a policyholder who knows the growth (after fees) or IRR of their existing insurance products or policies.

Calculating the IRR is of utmost importance in order to assess progress meaningfully. This calculation often reveals disheartening results.

However, choosing to do nothing due to potential penalties is akin to realising you are descending and about to crash but hesitating to pull up the plane’s nose for fear of stalling the engine.

Due to the way our brains function, we humans have a tendency to underestimate the impact of small numbers over extended periods of time. We fail to fully grasp the significance of such numbers.

To aid in understanding and highlighting the importance of your IRR, consider the following examples illustrating the impact of various net returns over a prolonged duration.

Furthermore, take a look at the graph that demonstrates how long-term growth has affected the returns of three multi-asset (high equity) funds based on a R100,000 investment made 20 years ago.

What about tax?

One aspect we often observe people neglecting in practice is their thinking, or lack thereof, when it comes to taxes. There is a tendency to overestimate the impact of immediate taxes, such as capital gains tax (CGT), while underestimating the impact of deferred taxes, such as CGT upon death and estate tax.

It’s important to remember that, much like in any game, the points that truly matter are not the ones accumulated in the first quarter, half or even three-quarters of the game, but rather the ones displayed on the scoreboard when the final whistle blows.

Insufficient planning in terms of structuring your financial affairs can result in a significant change in the scorecard for many when the final whistle blows.

Refer to the example below, which is based on a recent case handled by NinetyOne in one of their masterclasses.

Source: Ninety One

The individual owned a foreign equity portfolio, with over 70% of it invested in the US. Upon their passing (1), despite the availability of CGT rollover relief between spouses, there remained situs tax obligations (taxes in the jurisdiction where the assets were held) before the remaining balance could be transferred to the spouse.

Following the subsequent passing of the spouse (2), situs tax, along with CGT and estate tax, once again became payable.

If the CGT had been addressed earlier and the estate had been structured more effectively, the individual could have achieved a significantly improved net outcome for their family.

It is common for clients to refrain from making changes to their existing plans due to the anticipated CGT burden. However, this can result in a heavily concentrated portfolio that carries increased risk on one side, while potentially incurring substantial taxes in the future that could have been minimised by paying a smaller amount now.

If I may offer some advice: When making investment decisions, approach them with a fresh perspective and question whether you would construct your investment plan in the same way today. If the answer is no, it is likely that your plan requires adjustments.

Additionally, ensure that the performance of your investments is still aligned with your desired goals.

Elmie de Jager is a certified financial planner at Woodland Wealth. Contact her at info@woodlandwealth.co.za.

Although all possible care has been taken in the preparation of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone who intends to take any financial action based on this document is strongly advised to first consult with his/her personal financial advisor. Woodland Wealth is an authorised financial service provider with FSP no. 5966.