Financial planning is not about indiscriminately chasing investment returns – it’s about managing certainty of outcome.
Speaking at its 2nd annual Retirement Seminar, Peter Nieuwoudt, director and former chief executive of The Wealth Corporation, said to avoid errors of judgement and irrational financial decisions, investors need to follow a proper process. They have to understand risk, need to be able to predict investment returns with a reasonable degree of dependability over the long-term and need to manage outcomes with an appropriate asset allocation.
Once a financial plan has been devised (in consultation with a financial advisor), investors need to stick to it, he said.
Understanding volatility risk
The table below demonstrates the importance of managing volatility risk in retirement.
Source: The Wealth Corporation
If R100 is invested, R12 is withdrawn each year and the average annual return is 7%, the sequence of returns can make a significant difference to the amount of money that is left after ten years.
Nieuwoudt said if an investor received the same 7% return every year, he would have R30 left after a ten-year period. If he achieved higher returns in the early years, followed by lower returns, the investor would have R50 left after a decade. However, if the market performs poorly early on and higher returns only follow later, the investor would have nothing left after ten years.
“The same investment return with a different sequence of returns can have a dramatic impact on my investment outcome,” Nieuwoudt said.
A professional can help investors to construct a portfolio where risk and volatility are managed, he said.
“Without that one runs the risk of capital not lasting the distance.”
Nieuwoudt said while nobody knows what would happen in investment markets over the next year, investment return predictions become increasingly accurate the longer individuals stay invested.
Based on historic returns, the graph below shows that the probability of losing money in a well-constructed multi-asset investment portfolio over a one-year period is roughly 18%. It reduces to about 2% over a five-year period.
Source: The Wealth Corporation
Thereafter the probability of losing money is rather negligible.
“Volatility needs to be managed – not in the long-term but in the short-term.”
Nieuwoudt said a sensible financial management process considers the individual’s investment time horizon, future cash flows and a suitable asset allocation.
He said the pensioner’s short-term needs could be catered for by safer investments. Short-term volatility could be managed by investing the money needed for the next year or two in a money market fund. As the investment term is extended, growth assets could be added to the equation to capture better returns in the long run.
Asset allocation drives certainty of outcome in the long-term, he said.
Nieuwoudt said the role of a financial advisor is to help the pensioner to construct a plan that manages risks and creates more certainty.
In the preface to Benjamin Graham’s The Intelligent Investor, Warren Buffett wrote: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
It is important to have a proper financial planning process for making decisions, Nieuwoudt said.
Article credit: http://www.moneyweb.co.za/mymoney/moneyweb-financial-planning/avoid-irrational-investment-decisions/
