Whether you are accumulating capital for retirement, school or university expenses for your children or simply trying to ensure that you have money saved for an emergency, each financial goal requires some degree of equity exposure to achieve real long-term returns. Earl Van Zyl, head of Retail Product Development, discusses three golden rules for investing success.
Investing for real returns, which are the returns achieved after adjusting for inflation, should be top of mind for all long-term investors, throughout their investing journey. Achieving your goals by adopting this approach to investing is, however, simple to say but not easy to practise when the future is uncertain. It demands unwavering determination to stay committed to your investment strategy, even during turbulent times.
But what does this mean? Below I will discuss my three golden rules for achieving real investment returns.
Rule 1: Embrace equities for real long-term returns
Research shows that equity exposure has been one of the best ways to generate true wealth and meet long-term goals, no matter an investor’s stage of life. Different generations may have different investment objectives, but each phase requires meaningful equity exposure.
This is true in most circumstances: If you are accumulating capital towards retirement for the next 30 years or more; if you are nearing retirement with five to 10 years remaining before you have to sustain an income from your savings or if you are already in retirement, you need to invest for real returns. However, examining behavioural patterns across different life stages for investors who typically start to invest seriously from the age of 30, demonstrates the difficulty of maintaining equity exposure.
Millennials born between 1981 and 1996, and who have been investing seriously for only five or six years, may have been susceptible to recency bias, when South African equity performance has been disappointing. This bias, which makes investors overemphasise recent events when they forecast future long-term returns, can make it challenging to remain committed to equities, even when the real return stands at 5%, as was the case between 2017 and 2021.
For Generation X, or those born between 1965 and 1980, loss aversion may have proved to be more challenging in the period between 2001 and 2021. This is the tendency to try to avoid losses over equivalent gains. During this period, investors would have enjoyed a 7% annualised real return from equities, but only if they were able to stay committed to their strategy even during years that delivered negative real returns, which was true one-third of the time over the 21-year period. For those of the Silent Generation that may have been investing for the last 50 years, the real return from equities between 1971 and 2021 would have been 8% per year, with four out of every 10 years generating investment losses.
It really becomes a question of how to navigate our emotions so that we can stay committed to our investment goals.
Growth assets such as equities have also been extremely important in increasing the probability of reaching retirement with enough capital to draw an income from in retirement. Whether approaching retirement or just starting your working career, with a 30- to 40-year investment horizon ahead, accumulating sufficient savings between now and your retirement necessitates equity exposure of approximately 60%, depending on your contribution level. Contributing 15% of your salary may require at least 50% equity exposure, while saving only 10% requires an equity allocation of 80% to enter retirement with a similar level of capital. Once in retirement, if you want to be at least 80% certain of sustaining an income of 4% of your savings for 30 years, a minimum exposure of 50% to equities is necessary.
Rule 2: Manage your risk exposure – the importance of diversification and active management
It is true that equities are volatile, but they are necessary to achieve real returns. Employing an active asset manager who will carefully select equities and adjust your asset allocation over time is an effective way of mitigating investment risk. By way of example, when comparing the real returns of the actively managed Allan Gray Equity Fund from inception to 30 June 2023 with that of the South African equity market, the difference is clear. The market return was 10.0%, while the Equity Fund was 13.9%.
While equity exposure is required to achieve real returns, it is not the only asset class available. Careful active allocation across different asset classes such as bonds and cash is one way to have a well-diversified portfolio, which is another tool to manage investment risk. Diversification ensures that you have a portfolio of assets that perform differently under different circumstances. Within a multi-asset fund, like the Allan Gray Balanced Fund, for example, we can increase the bond exposure when bonds are cheap and equities are expensive, and vice versa, and we can increase the foreign exposure when South African assets look expensive. A well-diversified portfolio also takes the position size of individual instruments and their risks into consideration.
We spend our time ensuring that our portfolios are positioned to do well within a range of possible outcomes, focusing on the balance between the price we pay, the inherent uncertainty in how the future unfolds and tail risks.
Rule 3: Stay invested to benefit from compounding returns and to avoid market timing losses
Markets go up and down, and this cyclicality is an ever-present factor in investing. Returns in any given year are very rarely equal to the average annual return experienced over the very long term. It is important to remember that investment returns do not come in a straight line, with periods of poor returns often followed by periods of good returns. However, it is very difficult to predict correctly when markets are at their peak or their cyclical lows. Most investors who try to increase their returns or avoid losses by timing the market tend to get the timing wrong. Over the long term, this timing behaviour costs them in the form of lower returns than the returns delivered by the funds in which they are invested. The way to avoid giving in to the temptation to change your investment approach in response to market volatility is to stay focused on your long-term goals and not to respond to your emotions by trying to time the market with large changes in your portfolio when uncertainty dominates the headlines.