Three ways we destroy wealth
Even with the best of intentions, when it comes to building long-term wealth, it is all too easy to fall prey to common financial mistakes which could cost you thousands, and even hundreds of thousands of rands in the long run. After all, there is a reason that these mistakes are so common – as human beings, we share the same tendency to allow our emotions to rule our decision-making, even while we may be absolutely convinced that we are acting rationally.
But, as former US President Woodrow Wilson once said, “The way to stop financial joyriding is to arrest the chauffeur, not the automobile.” In other words, even more than how much you earn, the best guarantor of financial success is to look to your own behaviour, address any faults or weaknesses that may be obstructing your progress, and implement good financial habits.
With that in mind, here are three of the most widespread mistakes we make that lead to us destroying our own wealth:
1. Avoiding risk
I have met many investors who have allowed their fear of losing money, or their aversion to investment risk, prevent them from investing in aggressive asset classes such as equities. Instead, they opt for more conservative, less volatile cash investments.
At first glance, cash may seem safer and more comfortable than the rollercoaster ride of equities. But if your investments don’t keep up with inflation, which erodes the purchasing power of your money, you will gradually lose wealth in real terms. And when you finally realise that you may have invested too conservatively 20 or 30 years in the future, it may be too late to do anything about it.
Take, for instance, if you had invested R1,000 in a SA money market portfolio at the beginning of 2006. If your portfolio earned the average SA money market sector’s gross returns for the next 14 years, at the end of December 2019 your portfolio would be worth R2,692 – before factoring in tax and inflation.
Assuming that you pay annual tax of 26% on your portfolio’s interest earnings, and accounting for inflation, your investment would actually be worth just R896 in today’s value. In other words, the so-called “safe” investment would have lost you money in real terms after tax and inflation.
While past performance is no guarantee of future returns, if you had invested your R1,000 over the same period instead in the FTSE/JSE All Share Index (ALSI), your money would have grown to R4,352 before inflation. In real terms, or adjusting for inflation, your investment would have grown to R1,877 – more than double the amount of the cash investment.
*SA cash after tax assumes an annual tax of 26%
** Past performance is not a guarantee of future returns
Source: Cannon Asset Managers (2020)
My own first investment was a Tax-Free Savings Account (TFSA) which offered an extremely modest return of just 2.43%. When I realised that an inflation rate of about 5.5% would mean that my money would lose more than 3% in value in real terms over time, despite my consistency in saving, I quickly moved my investment to a portfolio with higher growth prospects.
While spreading investment risk across asset classes is always important, as long-term investors with a minimum of at least five years on your side, it is worth considering increasing your exposure to more aggressive asset classes such as equities. While not suited for short-term investments of a year or two, equities offer the potential for the greatest returns of any asset class if you have the time to ride out higher risk and volatility.
2. Ignoring the fine print
It’s common to find investors who picked their portfolios solely based on the brand or at the recommendation of friends and family members, without taking the time to understand what they are investing in or reading the fine print.
However, it’s absolutely vital to always do your homework before you choose an investment, and especially to take the time to understand what fees you may be charged, as measured by the portfolio’s Total Expense Ratio (TER) which can be found on every fund fact sheet.
Fees have a dramatic impact on investment outcomes over time. For example, assume that you invest in a portfolio for 30 years and that you achieve a real annual return of 8.5% after inflation. If your investment manager charges you a fee totaling 3%, this means that you would have lost 56.9% or more than half of your portfolio’s potential value to fees by the end of the 30-year period.
A 2% fee would mean sacrificing 42.8% of your portfolio’s potential value over 30 years. By contrast, a 1% or 0.5% fee would cost you just 24.3% and 12.9% over the same period respectively, as demonstrated below:
Table 1: The real cost of fees
*Assumes a real annual return of 8.5% over 30 years
Source: Cannon Asset Managers (2020)
Fees and low costs should not be the only measure by which you choose an investment, but as this example demonstrates, they are a key consideration. Another important measure for protecting your wealth and saving money is considering investing in a tax-efficient investment vehicle such as a retirement annuity (RA) or TFSA.
3. Being seduced into expensive credit purchases
Fantastic offers of low monthly installment payments tempt many people to take on debt to purchase luxury items they don’t need. South Africans particularly are a car-loving nation, and many people make the unfortunate mistake of trading in vehicles that are still being financed every two or three years all for the sake of “remaining relevant”. But allowing your ego or need for instant gratification to drive your financial decisions will significantly harm your ability to save, invest and build meaningful wealth.
Perhaps one of the easiest and most common mistakes to make in the vehicle financing arena is allowing yourself to be seduced by seemingly attractive credit structures with large balloon payments. These types of deals always appear to be a good offer, but what you may not realise is that you will pay interest on the balloon amount for the entire duration of the financing term – a silly mistake that I myself made when purchasing my first car.
So, if you were to take out a car loan with a simple interest rate of 11.5% and a 72-month term, and a final balloon payment amount of R60,000, the interest charged on the balloon payment alone would amount to R41,400 – totaling as much as 69% of the value of the balloon payment amount.
Together, these three mistakes, although common, could significantly derail your ability to grow your wealth, and could have a notable impact on your saving and investment outcomes. With this in mind, it is absolutely crucial to do your homework, and seek professional, objective financial advice to identify any blind spots in your financial and investment choices.