Cape Town – While there are numerous initiatives to promote a savings culture in South Africa, many people do not understand the difference between saving and investing, according to Steven Nathan, CEO of 10X Investments.
SA has one of the lowest savings rates in the world, according to the SA Reserve Bank.
Nathan explains that saving and investing are different activities, yet two sides of the same coin.
“Saving” means putting money aside for future use. It is spending postponed. That future use may relate to your year-end holiday, or your child’s university education in five years’ time, or to your retirement, still 30 years away, he explains.
“Although the state does provide an old age grant, this is a mere R1 410 per month at present, insufficient to maintain an acceptable standard of living. Nor can you expect anyone else – including your children – to provide for you,” said Nathan.
“Ideally, you should save 15% of your monthly wage or salary in a retirement fund, over your entire working life. This should be enough to maintain your accustomed life style in retirement, provided your money is invested appropriately.”
“Investing”, on the other hand, is what you do with your savings in order to earn a return.
“If you hide your spare cash in the sugar jar, you are saving, but you are not investing. Left alone, that money will not grow in amount or in value,” explains Nathan.
“While there may be thousands of investment vehicles, in most instances your money is usually invested in one of the following assets: company shares (local and international), government bonds, property and cash. The investment return is earned as interest, rent and dividends, or by way of a change in the price of the underlying asset.”
Money in the bank
When you save your money as cash in the bank, the risk is generally very low.
“You, therefore, earn a return that, over long periods, exceeds the inflation rate by only 1% per year, but you can be almost 100% sure that when you draw your money, you will receive all you put in initially, plus any accrued interest that is due to you,” he explains.
Share prices, on the other hand, move on a daily basis.
“You are, therefore, never sure how much money you will receive for your shares until the day you sell them. However, to compensate for this uncertainty, you are likely to earn a 6% to 7% per year real return from a well-diversified share portfolio that is held for many years,” says Nathan.
The constant rise in the cost of living – inflation – steadily eats away at the purchasing power of your money. Assuming a 6% inflation rate, the money you spend on a loaf of bread today will only buy you half a loaf in 12 years’ time. By the time you retire it may only buy you one slice.
Nathan says that depositing your money in the bank should at least preserve its purchasing power, but the money you accumulate this way will not be sufficient to pay for your retirement, unless you are willing to save much more than 15% of your income every month.
He explains that when saving at 15%, you are still dependent on the investment return to fund the bulk of your retirement.
“You therefore need to invest in assets that deliver a high real return over time – that is the share market. A balanced investment portfolio with a high proportion allocated to shares has historically delivered a long-term return of around 6% per year,” he says.
How will real growth of just 6% per year fund your retirement? Nathan says that it works through the phenomenon called compounding.
“Say you deposit the price of a loaf of bread today into an investment account that grows at 5% per annum in real terms (i e 6% pa net of a 1% pa fee). After 15 years, your investment should pay for two loaves of bread and after 40 years seven loaves,” he explains.
This is the effect of compounding, earning a return on your return. The longer you invest, the stronger the compounding effect becomes. Using the above example, it takes about 23 years to grow one loaf into three, a further 10 years to grow three loaves into five and then a mere seven years to grow five loaves into seven.
Nathan says the key lesson here is that you should start saving and investing as early as possible, to benefit from the strong compounding effect at the end of a long investment term.
“If you had saved your money in the bank, earning a 1% real return per year, you would only be able to buy a loaf and a half in 45 years’ time. In other words, even if you save diligently over your entire working life, investing in a low risk asset class could curtail your standard of living in retirement by as much as 80%. That is a much bigger risk than exposing your money to the share market over the long term,” warns Nathan.
Source: Fin24 http://ow.ly/ThU0b