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Investing in property often beats share-based investments

After the South African property market took a knock in 2007/2008, the space is now recovering. According to property expert David Rebe, now is a good time to buy property.

How to beat inflation

Investing long-term for your retirement is a matter of balancing risk with reward – the more risk you take on, the more reward you should expect. But in achieving this balance you must always beat inflation, Gareth Johnson, head of retail sales and distribution at Investment Solutions, warns.

“Your single biggest threat to retiring financially secure is inflation – both pre-retirement and in retirement,” he says.

Johnson says other factors that will impact on your retirement include what is happening in the local economy and in economies internationally, where you have invested your money, how much you save, how much you spend and how long you will live.

He says that to handle these diverse factors you need to know where you want to end up, not where you want to begin. This means that you need to understand your needs now and into the future.

You then need to design a plan, preferably with the assistance of a skilled financial planner, to get you to where you want to be. The plan must be based on an investment strategy that will need to be managed, monitored and reviewed regularly because of ever-changing economic conditions.

Johnson says the investment risks you take must be well considered and you need to avoid scams that promise returns that are out of the ordinary.

Your investment risk tolerance in saving for retirement will also be determined by your age. When you are young you should be investing in growth assets, which have higher volatility risk (the propensity to go up and down in value), lower inflation risk (the risk of inflation eroding your investment) but provide superior long-term rewards.

As you approach retirement, you need gradually to reduce exposure to risky assets while still generating inflation-beating returns. Your investment strategy just before you retire must look similar to the one you will follow in retirement.

When you reach retirement, the aim is to generate a sustainable income flow that beats inflation.

Your risk-return strategies will be determined by using and balancing the four basic asset classes – equities, bonds, property and cash – in various combinations to optimise returns while minimising risk. (See graph: “Asset class returns over 40 years”.)

Cash

This is money in an interest-earning bank account. Johnson says cash has the lowest volatility risk of the four major asset classes.

The advantages of cash are:

* There is no chance of losing your capital (the only threat is of the bank collapsing, which is very unlikely in South Africa);

* There is no volatility risk; and

* Your money is extremely liquid – you are able to access it very quickly.

The disadvantages of cash are:

* It provides the lowest returns of the four asset classes; and

* You are unlikely to beat inflation over the longer term.

bonds

Johnson says bonds are seen as complex instruments that are difficult to understand. Bonds are simply IOUs issued by governments and larger companies. They are contracts between you (as the lender) and a company or a government or a government institution, such as Eskom.

If a government needs to, say, finance the building of a dam, it may issue bonds with a maturation period of 20 or more years. It will pay interest at what is called the coupon rate for the period. If you hold the bond for the full period, you get your capital back plus interest (which is normally paid every six months).

But interest rates go up and down. This can have consequences for your bond. Depending on interest rates, a new bond issued later, say to build a power station, may offer a higher or lower coupon rate. If interest rates drop and the coupon rate on the power station bond is lower than the coupon rate on the bond for the dam, investors will be prepared to pay you more for your bond for the dam because it will provide better returns.

If interest rates go up, then you are not getting as good a return as you might receive, so you may want to sell the dam bond and buy the power station bond.

So, by trading bonds in a secondary market, you can make capital gains (and losses) as well as earn interest.

The advantages of bonds include:

* They tend to be less volatile (less risky than equities);

* They offer better returns than cash;

* They provide capital and interest returns;

* They are likely to beat inflation; and

* They have a low correlation to equities. In other words, they tend to provide better returns when stock markets are under-performing, and vice versa. This means that bonds can protect you against a stock market crash.

The disadvantages of bonds include:

 

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* Ordinary investors have difficulty understanding them.

* They may be vulnerable to inflation, although over the longer term, bonds have provided inflation-beating returns. You can also invest in inflation-linked bonds, which provide returns above inflation.

* They are vulnerable to interest rate changes.

property

Johnson says property investments do not include the property in which you live, because if you sell your home you need to buy another, unless you “buy down” and use the capital gain to supplement your future income.

As with bonds, property provides two streams of returns: potential capital gains and rental income.

There are a number of ways to invest in property. You can buy and own property, including residential, commercial and industrial property, directly, or you can invest in stock-market-listed property companies, either directly or indirectly through collective investment schemes.

The advantages of property investments include:

* They are likely to beat inflation over the long term;

* They have a low correlation to equities but tend to correlate with bonds because of the effect of interest-rate fluctuations, with high interest rates affecting property sales; and

* They offer a “halfway house” between bonds and equities.

The disadvantages of property investments include:

* Property prices can be cyclical and subject to price bubbles. Prices go up (often too high) and down over periods, making it difficult to make a profit when there is little demand.

* Directly owned property is illiquid (it can be difficult to sell).

* Property is often the playground of the unscrupulous. For example, thousands of people have recently lost money in property syndication schemes that have imploded. Many of the schemes were scams that targeted pensioners desperate for higher income flows.

Ostensibly, a property syndication scheme aims to pool together numerous investors to buy and develop property and who, as such, become part owners. But in most schemes, investors do not have any ownership rights in the property and are paid initial income flows from their own capital investment or that of others. Extremely high costs, including high commissions paid to financial advisers, condemn the schemes to failure.

Johnson says that if any investment sounds to be too good to be true, it will prove to be too good to be true.

equities

Companies sell shares to the public when they need to raise money for their business activities.

When you purchase shares (equities) in a company, you become a part owner of the company. As such, you are entitled to share in the company’s profits, but you are also exposed to potential losses.

As with bonds and property, you have a dual stream of potential returns: you can make capital gains from an increase in the value of a company and therefore its share price, and you share in the profits, which are paid out as dividends.

The advantages of equities include:

* Historically, they have provided the best returns of the four asset classes.

* They protect against inflation.

* They provide an increasing income stream. Dividends tend to increase over the years.

The disadvantages of equities include:

* Uncertainty. Equity investments provide no guarantees on either income or capital growth.

* They are volatile in that their price can go up and down, often very violently.

Johnson warns that many people think that they can take advantage of this volatility by buying and selling, but he says that very few people get the timing right.

It is time in the market, rather than market timing that will give you sound returns over the longer term, he says.

Johnson says that if you miss the top 10 days of equity market growth in a year you miss 90 percent of returns.

He says that you get negative years, but over time equities do provide annual average above-inflation returns.

Your personal inflation rate

If you do not invest so that the returns on your savings beat inflation, you are unlikely to have a financially secure retirement, Gareth Johnson, head of retail sales and distribution at Investment Solutions, says.

Johnson says a loaf of bread, which last year cost you R10, would have cost you one rand in 1985 and five rand in 2005. The bread has not changed. The ingredients are exactly |the same.

He says that it is important that you calculate your own rate of inflation, particularly in retirement, when you can expect your personal rate of inflation to be higher than the average inflation rate (as shown by the consumer price index – CPI – published by Statistics SA).

He says average inflation is based on an average basket of goods and services used by consumers. However, the ingredients in the basket vary significantly for people at different income levels and in different |age groups.

For example, only one percent of CPI inflation is dictated by health costs – yet there are very few people, as members of medical schemes, who spend so little on health care, and “as you get older you will spend more and more on medical costs”.

He points out that medical inflation (currently 9.2 percent) has been growing at a far faster rate than average inflation (currently 5.7 percent), meaning that someone who spends more than one percent of their income on health will have a higher personal inflation rate than someone who does not.

Source: http://www.iol.co.za/business/personal-finance/financial-planning/investments/investing-101-how-to-beat-inflation-1.1674984#.VHMa2tY2aCQ

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