All investments carry some degree of risk, and managing that risk is sadly not as easy as coughing into your elbow
Unless you're into extreme sports, risk is often an elusive concept, seemingly unconnected to our stable, suburban lives. The Covid-19 pandemic has changed all that. For many people - younger people, especially - the reality of risk has been made manifest.
For the first time, many of us have a real grasp on the term's meaning. Not washing your hands, not wearing a mask, not observing social distancing - all come with the clear risk of contracting the virus. You don't want to be infected or infect your family, so you change your behaviour and obey the rules.
When it comes to investing, the relationship between risk and behaviour plays out in a similar way. What does your financial planner mean when he or she talks about investment risk? Put simply, it's the probability of an investment's actual return differing from the expected return. All investments carry some degree of risk, and managing that risk is sadly not as easy as coughing into your elbow. But certain saving behaviours can help mitigate investment risk. One of the best is the constant rand plan - a winning wealth-creation strategy in uncertain times.
Here's what you need to know.
Rand cost averaging
The foundation of the constant rand plan is a concept called rand cost averaging - a strategy that involves regularly investing a fixed amount towards an investment that fluctuates in value, such as shares and unit trusts. By investing the same amount each month, regardless of the price of the investment, you benefit from bear and bull runs. In other words, you purchase more shares or unit trusts when the price is low and fewer when the price is high, thereby reducing the average cost of the investment, which increases in the long run. And as we all know, less cost means greater returns.
Rand cost averaging reduces risk since it removes the temptation of trying to time the market - trying to buy equity at the best price. It overrides emotional decision-making and instils sound investing habits.
For example, you might have had to take a salary cut during the Covid-19 lockdown, and the easiest way to balance your books is to pause your contribution towards your retirement fund. This is a natural human reaction - after all, the future is such an abstract concept and there are many daily concerns that require more urgent attention. But if you are in a position to do so, you should keep on contributing. If anything, you should increase your contribution in a declining market - doing so will get you more equity for less, and will enhance the benefits of rand cost averaging.
Magic of compound interest
The constant rand plan might owe much of its success to reduced cost of investment over time, but compound interest also plays a huge part. Initially, a small contribution each month might not seem significant, but give it enough time and you'll see the magic of compound interest at work. Compound interest is basically interest on interest - the result of reinvesting interest rather than paying it out, so that interest in the next period is earned on the principal sum as well as on previously accumulated interest.
Compound interest is more effective if you invest periodically in small amounts such as monthly debit orders as opposed to annual contributions. The more often compounding happens, the faster the growth. That's because each calculation is based on the latest account balance.
It takes discipline
The easiest way to implement the constant rand plan is to set up a monthly debit order towards an investment like a retirement annuity or a tax-free savings account. Put the debit order in place and trust that your money will do the work, regardless of market volatility.
But setting up a debit order is not the entire solution. If you want to maximise the benefits of rand cost averaging, it's equally important to keep an eye on the asset allocation of your monthly contribution and to check your portfolio is diversified across enough asset classes to provide some protection during market downturns.
While it's always best to seek the advice of a professional in this regard, this is more applicable now than ever before. Global markets are in turmoil and stability seems a long way away. A qualified financial planner has the requisite knowledge to ensure your monthly contribution works as hard as it should, allowing you to build the best possible future. Arrange a (virtual) meeting and start saving smartly.
Article reference: (https://www.businesslive.co.za/bt/money/2020-05-03-the-constant-rand-plan-a-step-to-wealth-creation/)
Business Live 3 May 2020
Hardi Swart CFP® , Managing Director Family Wealth Custodians and Financial Planner of the Year 2019
The information contained herein should not be construed as advice as defined in the FAIS Act.
Contact Hardi Swart at hardi@familywealth.co.za
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