As toddlers, my two daughters used to love our regular visits to the playpark and I vividly recall them rushing to get to the seesaw first.
Frequently, however, my eldest daughter thought it extremely funny to jump off while her little sister was still in the air, and of course that caused my youngest to hit the ground hard.
It’s these regular seesaw incidents that seem to fit so perfectly with my current opinion on risk and income needs from local shares.
I think most retirees will agree with me when I say that their financial situations, and more specifically the investment decisions or financial planning surrounding it, have taken a turn for the worse.
Food prices are constantly on the rise, medical expenses leave you even sicker after you’ve had to pay them off, and fuel prices keep soaring to new heights.
Retirees cannot afford to invest 100% of their capital in the money market, because the after-tax income at an average money market rate of 6.5% per year won’t be nearly enough to keep up with inflation.
Most of the retirees I speak to feel that the only asset class that can actually keep up with their personal inflation rate needs these days, is shares.
Historical data supports this theory and clearly shows that local shares yielded returns of inflation plus between 7% and 8% per year over the long term.
A few years ago, a reader emailed me and told me that investments and the income required from them is a problem that he solved very easily.
He said that because shares have yielded the highest returns over the long term, he invested 100% of his capital in shares and he now simply withdraws an income from it (i.e. he sells shares) as needed. As he put it: “because although there might be some volatility every now and then, the general trend over the long term is upwards.”
Even though he’s not entirely wrong, the real issue is the seesaw analogy.
Let’s use the last 10 years’ data as an example. Now, before I continue, I would like to disclose that I know better than most that the past 10 years market-wise have been all but fun and games.
Exactly 10 years ago, we were on the brink of one of the greatest corrections of all time, followed by a massive global recession, political unrest and almost no real growth in local shares over the last years.
Many people will argue about the chances of these events repeating themselves within the next 10 to 20 years. However, rather than arguing about the frequency of these events occurring, I’d rather like to focus on the risk such events hold for investors.
We all know what happened in 2008 when the FTSE/JSE All Share Index (JSE) lost nearly a quarter of its total value following the correction.
What not so many of you may know, is that up to and including its peak, the JSE grew by 16% before investors jumped off the seesaw, resulting in a nearly 40% drop.
Furthermore, the average annual returns delivered by the JSE was 12% per year over the last 10 years. If you were lucky enough to sell at the market peak each year, you would have earned more than 18% in returns per year.
On the flipside, if you found yourself on the other side of the JSE seesaw and sold at its lowest point each year, you wouldn’t only have seen absolutely ZERO positive returns over the last 10 years, but you would have experienced a 9% average decline in capital value annually.
How would this have affected investors who would have had to withdraw an income every year to live from? Unfortunately, it would have left them with a lot more grey hairs after retirement than before.
If they had retired exactly 10 years ago (assuming being fully invested) and required a 6% withdrawal rate that had to grow with inflation each year, they would have seen their capital fall to well below the initial investment value very quickly and they still wouldn’t have seen the initial investment value five years down the line.
On top of that, the inflation parasite would have eaten so far into their income by now, that there would be no way that their original income would be able to cover or pay for what it could cover or pay for five years ago.
Of course, no one plans to sell or withdraw at each low point in the market, but the risk remains real, especially if we consider soaring expenses and the possibility of unforeseen expenses, which definitely cannot be ruled out as you get older.
From a realistic standpoint, the majority of retirees – or those on the brink of retirement – simply cannot afford to place all their eggs in one basket and then get on a seesaw with that basket in hand.
The lesson we have to learn from this is that we should never only consider the long-term growth of a particular type of investment, but also the seesaw ride that comes with it.
Rather combine income investments with growth investments such as shares where an income from investments is required, to ensure that your hard-earned capital doesn’t hit the ground hard.