wealth - grow
                it and manage it

Building Wealth takes a great deal of energy and attention to detail.

Wealth measures one's ability to survive if all sources of income are removed. If you were to retire how would you survive?

What monthly income would you need?

How long would you and your spouse live after retirement?

These are determinants of how much capital (wealth) is needed to provide an adequate pension.

If you have 10 million invested you may feel that is adequate to provide a very good pension. If all the interest earned (assuming 8% pa) is used as a pension and nothing is reinvested, you would get a pension of 66 667 per month. However, over time, inflation (assume an average of 8%) would erode this to 8 333 if you are still needing a pension 30 years later.

Capital Invested (Inflation = 8%) 10 million 2.5 million
Provides Pension Monthly - Year 1 66 667 16 667
Provides Pension Monthly - Year 10 33 333   8 333
Provides Pension Monthly - Year 30   8 333   2 083

In creating wealth, it is also advisable to make provision in case something happens in your family (death, severe illness, disability). The best way to do this is through some form of life insurance to protect your wealth. Beware, the more insurance the salesman sells, the more profit he makes, and the more it costs you. Do not accept cover beyond a reasonable amount.

Recommended reading: The Informed Investor: A hype-free guide to constructing a sound financial portfolio by Frank Armstrong III (Amacom).

Before you embark on investing, some thoughts about Money!

It is important that you, as an investor, understand how money works. How else can you make it your servant? I would recommend you study a first year university/college-level Economics text-book (which includes Macro-Economics).

Money has value only because those who use it as a medium of exchange agree that it has the value printed on it. After the barter system, and going back over a hundred years, price was set in ounces (or parts thereof) of gold. To buy anything meant weighing out the right amount of gold dust, or cutting a piece off a lump of gold and weighing it. Then governments produced coins made of gold and silver, and the value of the coin was determined by its weight. This system didn't work, so government started producing paper money, printed with a promise to pay the bearer, on demand, the equivalent amount (value) in gold. Bank notes no longer make this promise. If you went to the central bank and demanded a bank not be exchanged, they would present you with an identical note.

Banks use money creatively (and legitimately) to create wealth for themselves by increasing the money supply:

Suppose you deposit 1,000,000. What does the bank do with it?

To prevent a 'run on the bank', the bank has to retain a portion. The rest it lends out again.

Transaction Deposit Amount Retained Amount = Loaned Amount Interest Earned
pa @ 10%
To illustrate: suppose the bank retains 50%*, it lends; 1 1,000,000 500,000 50,000
(In reality the actyual amount retained is small - around 10%) 2 500,000 250,000 25,000

3 250,000 125,000 12,500

4 125,000 61,250 6,125

...... 5-9



10 1,953.13 976.57 97.66
In 10 transactions the 'money supply' is almost doubled, and the bank earns another 1,000,000 in interest. Total 1,998,046.88
998,046
* In South Africa the SA Reserve Bank recently demanded that 12% is retained — so the amounts earned are significantly greater than shown.

Increase in the money supply is always inflationary. This explains why the Reserve Bank makes it much more expensive to borrow money – and to deter buying on credit – from the banking system by pushing up the interest rates.

When the State prints money the effect is also inflationary. Recently in Zimbabwe there was no money to pay the military and police, so the solution was to just print more – resulting in uncontrollable inflation at around 200-million percent per annum and growing.

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How, and Why, to plan for your Financial Future

Those who fail to plan: plan to fail!

You need to plan for the future. In your planning you need to consider three areas, and how much money is needed in each:

  • Short term provision of emergency funds. If you have a mortgage bond, this is the best place to build up an emergency reserve.
  • Medium term needs - to provide for things like children's education, as well as saving for things like motor vehicles (to avoid using credit).
  • Long Term needs - in particular retirement income (pension). You are likely to live 10 years longer than your parents, so the provision must be adequate to provide a pension for long enough.

In terms of the long-term plan you need to set a goal, such as: By age 65 I need to have enough capital invested to provide a pension of XXX per month.You need to take into account parameters, such as:

  • Interest rate return your investment is likely to get (caution - rather estimate using a low return).
  • Interest rate return your investment is likely to get (caution - rather estimate using a low return).

How much is enough? Assuming you need 30 000 per month as a pension, look at the scanarios in the table below. The interest rate earned means that if you can consistently get 15% you only need 3 million invested, but if you can only earn 5% then you need 7.5 million. In each case some of the interest earned is reinvested as a hedge against inflation. Before you think 30,000 per month is a lot, if you start drawing that at age 65, and live to 90, the real buying power will decrease considerably in those 25 years, which is why the more you can reinvest, the better.

Capital 5,000,000 7,500,000 3,000,000
Interest rate % pa 10 5 15
Interest earned pa 500,000 375,000 450,000
Interest re-invested 140,000 15,000 90,000
Annual Income 360,000 360,000 360,000
Monthly Income 30,000 30,000 30,000

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Know your Tolerance to Risk

opportunity cost

You have seen this before. 

The sooner one starts investing the easier (and cheaper) it is to attain a target. Sown graphically, as the number of years to retirement decreases, the amount needed to meet a capital amount (illustrated at 3.5million) escalates dramatically.

If you start investing 30 years before retirement you need only invest 1,000 per month (= total of 360,000); if you start with 20 years to go you need to invest 3,500 per month (a total of 840.000). (This ignores the effects of inflation on the value of money.)

What has this got to do with investment and risk?

When you are younger your attitude to risk is that you are willing to take greater risk (aggressive investment). This means you are willing to lose some of your investment balanced against the opportunity of much higher returns. If you lose some of your investment you have time to recover and get back on track to your overall goal.

Before investing you need to know what your attitude to risk is — this will affect the next page on portfolio building.

To determine your own attitude to risk — CLICK HERE — to open a risk-assessment questionnaire.

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Understand Banking and Insurance Companies

Banks and insurance companies are in business to create profits for their share-holders. They are not in business for the financial benefit of their customers (account-holders or policy-holders). They provide a service to both these, but their motivation is to do so in such a way as to perpetuate and increase their profits. For every service they provide there is a cost attached! At one level that is fine. They provide a service and I must expect to pay for that, just as I pay a plumber, a lawyer, a motor-mechanic. However, at another level, that is not fine as I, the customer have no space to negotiate what a reasonable charge is for the service provided, and often (usually?) the charges are not disclosed up front.

Both banks and insurance companies are highly profitable. It is interesting to reflect on the high degree of cross-shareholding they hold in one another. Insurance companies are very successful at investing their own funds and getting good growth, thereby boosting their profits further. Because of this success insurance companies think they are investment experts, which is not proven when it comes to investing and building client portfolios because the economies of scale are so different.

HOW THE COSTS ARE GATHERED:

BANKS

INSURANCE COMPANIES

On every transaction you make there is a charge. The system is complex. Some banks try to differentiate between costs, but essentially it is going to cost you the same wherever you bank.

On a policy a major component of cost is the commission payable to a broker / agent (who is not an employee, and the only income earned is commissions generated on sales).

When you use a credit / debit / charge card at a merchant, the merchant has to pay a fee (up to about 5%) of the amount to the bank. The merchant does not know what percentage of business is paid for by card, so has to build in the charge on all prices, thus increasing prices for everyone. The benefit for the merchant is that the availability of funds for the transaction is verified before being accepted.

On every policy there is a standard policy charge. This applies across the board, on life  other risk products, and investments, lasting for the term of the policy. On investments there are additional costs passed on to the policy-holder relating to buying and selling investments (usually unit trusts).

PROBLEMS

BANKS

INSURANCE COMPANIES

Banks are your friend, and fall over themselves to offer you credit facilities, while they are making huge profits - that is, while everything is going well financially for you.

But, have any sort of financial hiccup and you will see just how genuine this friendship really is!


The banks pay very low interest rates on any moneys deposited with them. The bank then lends this money (or the bulk of it) to other clients - see on 'understanding money'. Look at an example:

Amount Deposited: 1 000 000

Interest Paid (annual) @ 2% 20 000

Amount loaned:   920 000

Bank Earns @ 10%   92 000

Bank's profit  72 000

Remember too, that the money loaned is recycled, so the process grows, and the profits increase.

If you have any service compliments or complaints (with banks or insurance companies, you can now report them to:

tell the world on hellopeter.com


The insurance companies are concerned that clients do not have unrealistic expectations of how their investments will grow. The growth is not generally guaranteed, and where it is, there is a significant cost attached to getting the guarantee. Insurers illustrate growth returns. In South Africa, by agreement, this illustration is shown between a high of 10% and low of 5%.


This creates further difficulties:

  • The agent / broker who structures the investment does not understand what he / she is doing so structures the investment, usually without reference to the client's risk tolerance, in a few favourite funds.
  • The range of 5% - 10% becomes a target, and the agent is happy if the investment beats 5%, irrespective of what the market conditions are.
  • The illustrated value is calculated on the full premium paid. After costs the amount actually invested is lower, so the returns will, in turn, be even lower.

When an investment policy is cancelled three things happen:

  • the insurer has paid commission over to the broker or agent calculated on the whole term of the policy. This will be reclaimed from the sales-person. This commission is not repaid to the policy-holder, although it was paid out of the premiums paid.
  • the value in the policy is often dramatically eroded as the insurerer recoups all the costs they would have earned over the term of the policy.
  • the insurer pockets the commission and the penalty costs, and the insured client is left sucking the proverbial hind tit.

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There are so many ways to invest, it is so confusing! Asset Types

be an informed investor & make the right choices

be aware of the risk
                      associated with any investment diversificataion is the key to
                      successful investment

When you enter into any investment, or choose an investment strategy, you must know what level of risk is attached to that investment medium.

The level of risk determines two things, in general:

  • Low risk: usually lower returns; less chance of loss of investment.
  • High risk: usually higher returns; with greater risk of losing investment.

So, before investing, know what risk you are accepting, and evaluate, on an on-going basis, whether the risk has changed.

The discussion on the rest of this wealth-building section centers around unit trusts as the suggested investment medium of choice, and, below, mention is made of diversification within an investment portfolio.

If you choose to use more than one investment type, the principle is still to diversify. Thus, for example, you invest in residential property, reduce your risk by, alongside this, investing in, perhaps, unit trusts.

Property as Investment  Shares  Bonds  Money Market  Entrepeneurship  Offshore Investment? 
  Unit Trust Funds / Mutual Funds   How to select Unit Trusts

Click on item to go to relevant article

Property as Investment

The way to build a property investment portfolio is slowly, and gently.

Now, having got accustomed to paying 6,607 per month, rent the first house and buy a second house and live in it. The rental on the first house is usually around 1% of the value = 5,000 per month. Your new house of value 800,000 can be repaid in under 10 years.

Now repeat the process — your rental income is now 13,000 per month, so you can now afford a house of around 1,5mllion. 

Or instead of constantly upgrading, keep to houses around the same value as your first one, and buy 2 or 3 or more at a time. 

These calculations leave out the factor that property is generally increasing in value and price all the time (with ups and downs).Your return on investment is measured in the growth in value of your investment holding plus rental incomes received. The risk associated with this is that rental may not be paid (a downturn in the economy may mean people can't afford the rents you require). If you hit this scenario, it would be helpful to have diversified in other investments so you can draw on those to cover the shortfall. Of course you can always sell property you hold, but are unlikely to get a meaningful price in a buyer's market.

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Shares — The Stock Exchange

Trading on the Stock Exchange for shares or futures or bonds is, potentially perhaps, the most lucrative way of investing money to maximise growth. But, taking risk into account and making sure one is not too exposed to risk is an almost full-time occupation. Building wealth takes lots of hard work and attention to detail - and that is particularly true of the stock market route. The big investment companies have departments who are fully occupied monitoring and managing their investment department's exposure to risk.

By all means, try this as an avenue for your investment, but always ensure you hold sufficient diversity. One of the advantages of Unit Trusts / Mutual Funds is that the holding company has fund managers who evaluate risk and potential for growth within the whole portfolio of shares (or other investments) that are held. For this reason, the remainder of this site looks only at Unit Trust / Mutual Funds as a recommended vehicle for wealth creation (not excluding any other asset class). Having said that, a word of caution: Because it is important to know what is going on in your investment, full dsclosure becomes a major issue. Unit Trust / Mutual Funds do not always adequately disclose their cost structures, so that may introduce an additional risk factor. (In the late 1980s I was consulting to a major insurance company in South Africa, which had built a massive office block in Sandton, South Africa. This package actually made the company insolvent, and they were swallowed up by another insurer which was 20% of their size. The new company got out of that building very quickly. It is now owned by one of South Africa's largest investment groups. Makes one think what costs they are hiding.)

buy low - sell high!The danger with investing in shares is that you buy at the highest price and sell at a low price — a purely emotional reaction to price fluctuations — and a certain way to make big losses. Ideally, buy low and sell high — that is the skill of a successful investor.

To invest in the stock exchange one typically needs to appoint an investment / stock-broker (who has a dual function of buying on your behalf, and of advising you of perceived good deals.) Some banks provide the service of buying shares on your behalf. You need to know the costs involved using a broker or bank, and factor this into your planning.

Having said that the stock market takes a lot of energy and effort, help is at hand. There are competent, effective stock market analysts around, who can do much of the leg work for you. One I recommend in South Africa is Frank Black (a former colleague in a different industry). Look at his web site: Stock Market Performer or contact him via email:

Part of what makes investment in shares difficult, and exciting, is there is so much to watch. It is not just about the share price, which can fluctuate wildly. (Taking a snapshot, which is not a good test, one share grew by 178% in a week; another dropped by 27.5%.)

Then, another thing to consider is the Price-Earnings ratio (PE). Leaving aside fluctuations in price, the PE measures growth in terms of dividends paid (usually annual). If the dividend is 10% of the price of the share (PE = 10) in ten years the value of your investment would double.

If the PE ratio is 3 or 4, say, your investment is going to grow slowly. The market labels shares according to their PE ratio. 'Growth' shares have a PE of higher than 10; 'Value' shares have a PE of less than 10. Which do you choose?

Look at what the markets and the economy are doing. Value shares are favoured when the markets are down, known as a Bear market. Growth shares are favoured when the market is up, known as a Bull market. This puts a different spin on the advice above, 'buy low - sell high', as it introduces another factor other than share price - PE ratio.

Again, the rules of diversification against your risk tolerance profile apply. By all means mix, judiciously, growth and value. But, as stated above, investing in shares requires constant attention.

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Bonds

When a government needs a capital injection - usually for major projects, such aas roads or power stations - they raise this money by asking investors to loan them money for a fixed period, with guaranteed returns at the end of the period.

The guaranteed rate is usually linked to prime lending rates at that time - so, the higher the inflation-rate is, the higher the return will be. However it is important to assess the risk before buying into a bond scheme. For example, I would not put any money into a bond raised by the current Zimbabwe government.

Bonds can be traded, rather like shares - so one is not locked in for the full term.

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The Money Market

The Money Market is generally a safe - therefore very conservative - investment medium. The rate of return is linked to interest rates (prime lending rates). The higher these are, the better the money market will perform. This is a two-edged sword, as higher interest rates indicate higher inflation - which may eat into your profits.

I do not recommend Money Market for long-term investment. It is, however, a good place to hold funds while you accumulate a lump sum to invest elsewhere later.

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Entrepeneurship

Another good way of making a lot of money quickly is by setting up a lucrative business for yourself, or invest in someone else's lucrative business.

How do you know it will be lucrative?

The simple answer is that you don't. It may have as much chance of collapsing, and you will lose your whole investment. You will have to go on the quality of the business plan and your intuition. Would you have invested in Henry Ford's plan to manufacture motor cars?

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What about offshore investments?

Some years ago, when The US$-Rand exchange rate was over 12 Rand to the Dollar, accountants were advising clients frantically to invest offshore. The problem is that this introduced a second risk category, as investors were gambling on exchange rates. The result was that many lost 50% of their investment. Now accountants, having learnt from experience — did you know that is possible? — are advising clients to go money market. Yes, that is safe, and should form part of a diversified portfolio. As interest rates increase, money market options are going to perform better, as the money market rates are linked to interest rates.

So, what about offshore investment?

Trevor Garvin, head of multi-management at BoE Private Clients, said recently (Finweek Winter 2008 review of SA funds), 

Investing one's assets offshore offers you exposure to global financial markets and products that may not be available locally, and can serve as a useful hedge against the variables of the domestic economy. When considering investing offshore, however, it is important to follow the accepted investment principle of appropriate diversification — in accordance with the risk profile and personal circumstances of the investor — rather than investing in any single asset or asset class. (emphasis added)

Yes, choose carefully, and spread your risk by adequate diversification across your whole portfolio, and choose more than one offshore investment if you go that route.

Investors should maintain an adequately diversified portfolio says Peter Brooke, head of Old Mutual Investment Group's SA's (OMIGSA) Macro Strategy Investments boutique. He continues (Finweek Winter 2008 review of SA funds):

A fundamental principle of investing is that diversification across multiple asset classes helps lower a portfolio's risks. That's sound advice, especially during current times of high market volatility. ...

Investors shouldn't panic, but instead ensure they maintain an appropriately diversified portfolio that meets their long-tem investment needs and risk/return profile. ...

Brooke goes on to show that active management of one's portfolio (or by a fund manager of a unit trust fund) is more effective than passive management (essentially just sitting there and waiting for the swings to happen).

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Unit Trusts (aka Mutual Funds)

Unit Trusts are set up by various ivestment companies as investment vehicles. Each unit trust fund will be defed within a specific market sector. The designation —eg. a Growth Fund — will often give you, the investor, a guide to the mandate that the investment company has given to the fund manager. Unit Trust investment portfolios are used extensively by pension fund managers and insurance companies when structuring the underlying investment in a client's retirement annuity (RA) or endowment policy.

The advantage is that, because the fund manager's job is to ensure that that specific fund performs within prestated parameters, the pension fund manager (or whoever — including you) can adopt a basically hands-off approach — and occasional look is all that is needed.

Most investment companies will allow you to buy a lump sum of units, or set up a debit-order system of drawing the amount you can afford each month. The second does not lend itself to easy diversification, unless you set up several debit-orders (at an ever-multiplying cost to you).

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Selecting Unit Trusts

Having selected — according to your risk tolerance, which sectors of the unit-trust offerings you want to focus on — you are presented with a daunting list of unit trust funds available to you in the media. Which ones will do what you expect and desire?

Firstly, it is helpful to get an idea of what the manager of any fund is trying to achieve. To do this you need to study the financial media, particularly Business Day, Financial Mail and Finweek. For example, let's look at a couple of examples (not named) from the Domestic Targetted Absolute and Real Return Funds sector:


(price cents) NAV Costs % initial TER Returns %
3 months
Returns %
1 Year
Returns %
3 Year
1 128.41 0.00 1.47 1.32 4.3 8.39
2 165.27 3.42 N/A 8.76 24.76
3 1748.02 3.42 2.68 3.39 -2.01 15.79
NAV = Net Asset Value including VAT. If you have R100.00 to invest divide, R100 by, for example the first, 128.41  - you can buy 77.876 units.
TER = Total Expense Ratio (based on the previous calendar year), and reflects the underlying charges, fees and levies associated with the unit trust.

These funds fall in the conservative category. The aim of the fund manager should be to beat inflation by a fixed percentage (not high), and the advantage is that your capital is guaranteed.

What is the average inflation? Do not look at the latest figure! Over the past year it is perhaps around the 8% mark, so choose a fund that is doing (choose what) 10% or 11% or 12%. The first fund is below that on 1 year — but is close on the 3 year range. The second fund is doing very much better — about twice as well. This should sound warning bells for the cautious investor, as this looks more like a varied equity fund. The third fund is expensive and has shown a negative performance over 1 year. On reflection, I would probably avoid all three.

This topic flows into the next - Design your Portfolio.

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Design Your Portfolio


Having just looked at the variety of investment types, the discussion here centres on the construction of an effective portfolio using unit trust funds (aka mutual funds).

diversification is the key to
                        efective investmentis the key to efective investment.

Over time, all investments fluctuate. This will apply to individual funds and market sectors, as well as the total economy. You have no control over this. To try to achieve a smoothed average you need to select enough investments to try to balance out the fluctuations. This also means spreading investment across several market sectors (because market forces tend to operate in sectors)

investments
                        fluctuate - buy and sell at right momentsIt is important — in the short term — to buy when they are near the bottom of the curve, and sell near the top.

How do you structure your portfolio?

Firstly choose how many funds you want. 15 is adequate diversification; 20 is better. The, using the table below, choose funds in risk categories appropriate for your risk tolerance.

How do you select funds?

  1. Know your tolerance to risk (see Risk page under Wealth tab).
  2. Choose funds in appropriate ratios to your risk tolerance — according to the table below — to see it in chart form click here.
Your Risk Tolerance Conservative Funds Moderate Funds Aggressive Funds
Conservative 45% 40% 15%
Moderately Conservative 35% 50% 15%
Moderate 25% 55% 20%
Moderately Aggressive 15% 55% 30%
Aggressive 10% 35% 55%

It may seem anomolous that a conservative portfolio should have some aggressive funds in it, but research has shown that this reduces the overall risk.

What market sectors fall into the different risk categories?

In the table below these are ranked from lower to higher risk within the category. Warning: This is a superficial analysis and may change over time, and be different in different economies.

Conservative sectors (lower risk and lower returns) Moderate Aggressive sectors (higher risk but may give higher returns)
Resources Large Capitalisation Funds Small Capitalisation Funds
Money Market Funds Index-tracking funds Emerging Company Funds
Bond Funds

Property Funds

Income Funds

Value Funds

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Having built your portfolio, you must now track its performance

There are two keys to ongoing successful investment:

  • Create diversified portfolio(s), structured according to your risk tolerance (and note that your risk tolerance will change over time), and
  • Regular, ongoing measurement and evaluation of the portfolio's total performance, and appropriate remedial action.

This is your investment and financial future — it is your responsibility!

If your portfolio is invested through an insurance product (Retirement Annuity or other investment product) be aware that there are costs deducted. So your tracking needs to be on the net amount actually invested.

  • When you make your investment choices to build the portfolio, you have created a list and you know how much money is allocated to each fund (starting value).
  • Get regular reports of how the investment is performing. If you have purchased unit trusts (mutual funds) or shares the values are available in the financial sections of newspapers or other financial media. If using an insurance product get values from the insurer.
  • Record these values and calculate growth as a percentage of the starting figure. The calculation of this (annualised) is (Present Value minus Starting Value) over Starting Value times (number of months divided by 12).
  • Remember - All investments fluctuate. Do not over-react if one or more show negative growth. You should wait at least a year before taking any remedial action (selling / replacing funds).

assess remedial action by
                where the investment is in its cycleHow do you assess remedial action to be taken? 

If you sell a fund that is showing negaitive growth you are taking a loss. If you do that repeatedly you will show a big loss.

Ideally, if you are going to sell anything, it should be at or near the top of a cycle. When you buy, the zone is at or near the bottom of the cycle.

An advantage of unit trusts is that the fund managers will be taking remedial action within the fund to minimise or hedge losses.

How do you track monthly (recurring) investment performance (e.g. Annuity Investments)?

These are not as easy to track as lump-sum investments, so, when you get a value statement from your insurer / service provider, see what the net amount (after commissions and fees) is that is allocated to the investment:

  • Using a spreadsheet (or financial calculator) calculate:
  • Future Value = (Monthly Rate, Number of Payments, Payment amount (negative))
  • For example: FV(10%/12,27,-970) = 29 234.52
If your value shown by the insurer is 28 910, you can see that 10% is too high, so make a minor adjustment to the monthly rate till you see what the actual rate achieved is - in this case 9%.

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