Investment Basics III: Unit Trusts and Index Funds

This post has been a long time coming, sorry wonderful readers! Life has been good and busy lately so I suppose you can take it as a good thing that I don't prioritise writing the blog over living in the real world :-) That being said, I do enjoy writing these posts and I do believe that they are fulfilling a need. It's good to be behind the keyboard again.

Today's post continues our mini-series on Investment Basics. In the previous post we covered the basics of what shares are and we ended with the idea that diversification is important. We want access to lots of shares and we want to make it as easy as possible and as cost-effective as possible to own these shares. This is where Collective Investment Schemes (CIS) come in. 

1. Collective investment schemes help overcome the prohibitive mass of capital required to invest

Dale, Ellen and Felicity are good friends looking to invest in three top South African companies. Dale has R 1 000 to invest. Ellen has R 1 500 to invest and Felicity has R 500 to invest.

They want to be diversified so they don't want to buy shares in a single company. They definitely want to own all three companies. From the table above, the minimum investment that each of them would need to make is R 3 000 (1 000 + 800 + 1 200) if they buy just one share of each company. But none of them have this kind of money at the moment! Ellen has the great idea of pooling all their money, buying the shares together and then owning them collectively. Collectively they have the R 3 000 (1 000 + 1 500 + 500) required to purchase one of each share. Collectively they will own one of each share and individually they will own a fraction of a share that is proportional to the amount that each of them put into the collective investment.

So by pooling their resources Dale, Ellen and Felicity are able to achieve diversification that would not have been able to achieve by themselves.

2. Collective investment schemes help reduce trading costs

When buying shares there are various costs involved:

• IPL (Investor Protection Levy) for 0,0002% of the value of the trade (excluding VAT). This is to fund the Financial Services Board's investigations into insider trading.
• STRATE (Share TRansactions Totally Electronic) costs R 10,92 for trades below R 200 000 , 0,005459% of the value of the trade between R 200 000 and R 1 000 000 and R54,59 for trades over R1 000 000 (all excluding VAT). This is trading cost associated with keeping electronic records of all shares traded on the Johannesburg Stock Exchange.
• STT (Securities Transfer Tax) for 0,25% of the value of the trade. This is only applicable when buying shares.

The above three costs (IPL, STRATE and STT) are fixed and in general will not differ from one stock broker to another. The only real cost that differs between stock brokers are:

• Commission charged on each trade. These typically range from 0,2% through to about 0,6%. There is usually a minimum brokerage which ranges from R 20 to R120. The minimum effectively means that you only achieve the stated commission percentage after investing a minimum amount. For example with a commission percentage of 0,2% and a minimum commission of R 20 the most efficient investment is R 10 000 (20 divided by 0,2%). For smaller trades you still pay your R 20 commission which will represent more than 0,2% of the amount invested.
• Ongoing 'platform fees'. These are either fixed monthly or annual fees or are a percentage of your total portfolio with the stock broker. A portfolio generally doesn't need to be that large before the fixed fee option is more cost-effective. Some stockbrokers do not charge platform fees for certain products (such as Tax Free Savings Accounts or if only Exchange Traded Funds are purchased).

Okay, enough of the dull theory of the different costs associated with trading shares. Suffice it to say that there are costs involved and that we want to minimise these costs so that more of our money actually ends up in our investment. Let's imagine a slightly different scenario which takes trading costs into account.

Dale, Ellen and Felicity each have R 3000 to invest in the following companies:

Let's also assume that they each have enough extra money to cover the trading costs. What we want to compare here is the total trading cost to each of them if they buy one of each share individually (Scenario 1, with a total of nine trades made) or if they pool their money and buy three of each share (Scenario 2, with a total of three trades made). If you want to skip the details of the following table feel free to go straight to the conclusion. I won't mind. This table is for those of you who really want to see exactly how costs the various trading costs are calculated. In the table below I've assumed a minimum brokerage commission of R 9,00 per trade (at 0,3% which means the minimum trade required to actually achieve the 0,3% would be R 3000). Wherever I've multiplied by 1,14 I'm taking VAT of 14% into account. In the table you can see that the only costs that are affected by the number of trades made are STRATE and the broker's commission. 

Although Dale, Ellen and Felicity could afford to buy one of each share by themselves, by pooling their resources, these three investors have managed to reduce their trading costs. Great!

So in summary, investing collectively does the following.

1. Reduces the amount of capital needed to achieve diversification.
2. Reduces the trading costs associated with purchasing shares.

Types of Collective Investment Schemes

Unit Trusts

Unit trusts (also known as mutual funds) are a type of collective investment scheme set up by various financial institutions that formalise the above process except on a much larger scale - we're talking millions or billions of rands in the total fund and tens or hundreds of thousands of investors!

You can get unit trusts with different allocations between equities, bonds and cash. Equity funds generally have about 100% exposure to equities and will offer the best growth over the long term. Balanced funds can have up to 75% invested in equities with the remainder invested in less volatile asset classes (bonds and cash). These balanced funds suffer less in an economic downturn and are eligible for use in retirement products (they are Regulation 28 compliant), but they will experience less growth than pure equity funds in the long term. You can also find funds that focus on investing in property or that invest in companies that pay good dividends.

The good things you get from a unit trust:

+ Trading costs are spread out across a large number of people.

+ Diversification is really easy to achieve.

+ You don't need to micromanage selecting, trading and keeping track of different shares.

On the other hand:

− You give up some control (someone else chooses individual shares to buy).

−  You're paying someone (a fund manager) to make choices for you. These costs can add up and you don't necessarily always get value from an active fund manger.

A range of actively managed funds can be bought from various providers. My personal favourite is Allan Gray. Before you choose a fund you should take a look at the fund "fact sheet" for that fund (just Google the name of the find together with the words 'fact sheet') so that you know what you're investing in.

Index Investing

Index funds are passively managed and stand in contrast to traditional unit trusts which are actively managed. 

With active management a fund manger is employed by the fund to do research into the various companies available on the stock market and to choose which companies to invest in and how much to invest in each company. These decisions are not once off and the active fund manger will buy and sell shares in accordance with how they read the prevailing market conditions.

With index funds (sometimes also called tracker funds), a computer is used to track a given index (essentially a weighted average of different companies satisfying specific criteria). For example, a fund may track the top 40 companies in the stock exchange. As the various companies grow and shrink or move into or out of the index (the top 40 in our previous example), sales and purchases of an appropriate number of shares are done automatically. An active manager is not required to do research into which companies offer value. The costs of most index funds are thus much lower than those of a traditional unit trusts. (The ongoing costs of most actively managed funds are between 1,5% to 2,5% with most index funds closer to 0,5%).

For more on index investing see Mom and Dad Money, Mr Money Mustache or jlcollinsnh. All good reads with explanations far better than my own :-)

Essentially with an index fund you will always get the returns of the market. You won't beat the market, but you also won't under perform the market. Since the market inevitably keeps growing this is not a bad thing and for long-term serious investors they are a really great tool. With actively managed funds there is potential to beat the market, but with that potential is the ability to under perform the market . Very few active managers will actually beat the market and there's no real way of predicting from one year to the next who those active managers are going to be. In which case there was no point paying additional management fees if you would have been able to get the returns of the market through a passively managed index fund. 

You can get unit trust index funds as well as Exchange Traded Funds (ETFs). The difference between these? Not much. The main difference is to do with how they are traded. 

Unit trust index funds can be bought from Linked Investment Services Providers (LISPs) and are priced once per day. There are usually no costs associated with purchasing, selling or switching between these funds. However, there is usually a management fee and the internal costs associated with managing these funds are often (slightly) more expensive than ETFs (about 0,4% is pretty good). We have quite a few unit trust index funds with Sygnia.

ETFs are bought directly from stockbrokers and trade in the exact same way as shares. So unlike their unit trust counterparts there are broker commissions payable when trading ETFs. However, the ongoing costs can often be lower with lower internal costs (you can get certain good ETFs in South Africa for as low as 0,2%). Our main ETF at the moment is the RMB Top 40 (which aims to replicate the Top 40 Index) which has a total expense ratio of about 0,2%.

So do you go with unit trust index funds or ETFs? Or both? Here's a table summarising the main differences between unit trust index funds and ETFs:

In short, if you're investing for the long term and you know what funds you want to invest in then ETFs are a good way to go. If you're investing for a slightly shorter term or you want the flexibility to change funds without worrying about the cost of doing so then unit trust index funds may be more appropriate. There is also absolutely nothing wrong with a blend of the two. 

My wife and I have a good mix between actively managed unit trusts (where we started), unit trust index funds and exchange traded funds. We're heading more and more towards ETFs, but we're holding on to the actively managed unit trust funds that we've accumulated so far.

Hopefully this post has helped you better understand how to achieve diversification in a pretty easy and safe way. I know it's been a bit technical but feel free to use the summarised bits if you want to skip over the details:

The Executive Summary

1. Diversification is important. We want access to as many (good) shares as possible, as easily and as cost-effective as possible.
2. The best way to do this is through making use of collective investments schemes.
3. Actively managed unit trust funds are one way to go. They cost more than index funds. My personal port of call for actively managed funds is directly from Allan Gray online.
4. Index funds come in two main types, unit trust index funds and ETFs. They are very similar products and will experience similar growth. The differences are only really in how they are traded and the costs of trading. Index funds are cheaper than actively managed funds. My personal port of call for unit trust index funds is through Sygnia and for ETFs through ABSA Stockbrokers.
5. As with any summary (and here I'm referring to the blog post as a whole) there are subtleties and other options that I've ignored. These are just the basics to get you going.

Yours frugally

Mr Cent(ri)frugal Force

Investment Basics II: Shares

This post is designed to sort out some terminology that can be a bit confusing in the investment arena. Starting to invest can seem like a really scary thing. I know that when I first started I was almost too scared to actually start because there just seemed so much to know. It turns out that, yes, there is a lot to know, but not that much that you really need to know before you start. The important thing is actually to dive in and start once you've got the Basic Theory and Good Investing Principles down. Don't wait until you know everything before you start - remember that time in the market is one of your biggest friends when it comes to compound growth.

Shares / Stocks

What does it mean to invest in the stock market or to buy shares? A share is a very small part of a company that has chosen to list on a stock exchange. When you buy a share you actually own a small piece of that company. Let's do this by way of example.

Bob and Mike start a pizza company. They're extremely creative in the kitchen, but not so much when it comes to names. So they decide to call their company Bob & Mike's Pizza Company. Bob has R600 to invest in the company and Mike has R400 to invest. So to be fair, they agree that Bob will have 60% of the company and Mike will own 40% of the company. The initial total investment in the company was R1 000 and this was the value of the company. Several years pass [pages fly off a calendar, a clock spins really fast and a sun rises and sets several times through a window] and before they know it, their pizza company is worth R10 000. How did it get there? They've been working hard for years and any profits that they have made they've put back into the company (after taking modest salaries for themselves to fund their frugal lifestyles).

At this stage Bob and Mike decide that it's time to expand. They don't have any more of their own money to put in so they list on the Johannesburg Stock Exchange so that the public can invest in their company. Sure, they'll have to start sharing their earnings with the members of the public who are brave enough to invest, but the profits will be bigger too. Without access to additional capital from the public their growth will be severely limited (and you thought crowdsourcing was something new?). Bob and Mike decide to slice their company up into 10 shares. Bob keeps three slices of the company and Mike keeps two slices (in keeping with their original 3:2 ratio of capital injection into the company). The remaining five shares they make available for sale. I'm a huge fan of pizza and I've been wanting to diversify into the industry for a while so I decide to buy one of the shares on their first day of trading which leaves four slices still available on the market for other potential investors.

Bob & Mike's Pizza Co.
Photo of original pizza: Food Recipes (CC-BY 2.0)

So how much does this one share cost me? Well in principle each share should be sold for the total value of the company (R10 000 on the day of listing on the JSE) divided by the number of shares issued (in this case ten shares). A simple way to calculate the price of a share would look like this:

Using this simple model my single slice of Bob & Mike's Pizza Co will cost me R1 000. Okay, fine. I now own 10% of a pizza company (1 share out of the 10 issued). 

What does owning a share do for me?

1. The company pays me a share of the profits.

As the company earns money, I get my fair share of the profits. Now a company will not always pay out all of the profit to its shareholders. Some profit is retained by the company to aid future growth. Whatever profit is left over is paid out to the shareholders per share so the shareholders who own more shares get more of the profits. When a company pays outs profits to shareholders these are called dividends.

If Mike & Bob's Pizza Co. makes R2 000 profit in the year following my share purchase they may decide to keep R1000 in the company to keep it growing. The remaining R1 000 of profit gets paid out to the shareholders. Because there were 10 shares the divident payout will be R100 per share and I will receive R100 because I own one share. Bob owns three shares so he will get R300 and Mike owns two shares so he will get R200. If the remaining four shares haven't been bought yet, then they are still owned by the company and those dividends are retained.

2. My share increases in value as the company grows. 

My investment has helped the company to grow (they can buy a bigger and faster pizza oven, hire more delivery staff start a new branch in a nearby suburb etc.). As the company's value increases the value of my share increases (and here's the important bit) without me needed to put in any additional money or work. If after a few years [more pages fly off a calendar] the company is worth R20 000 (according to the company's books) then my share (being 10% of the company) will be worth R2 000. 

This might be the actual value of the share, but this can be very different from the market value (what you pay for to buy a share and what you get you you sell a share). A more realistic share price calculation looks like this:

The market value  of a share depends on how the company is seen by the public (prospective investors as well as customers), how many shares are actually available for sale and how the company is expected to perform in the future. This is where most of the volatility of investing in the stock market comes in. The market share price goes up and down throughout the day and from day to day without the actual share value necessarily changing. The actual share value does change, but not from one second to the next. The actual share value changes as the company earns profits (and puts them back into company so that it keeps growing) or as the company makes losses. In the long run the the market share price can't help but mirror the actual share price. Public perception (and all the other complicating factors) can skew the share price in either direction at any one moment or even for several months or years at a time, but over a long period of time the actual value of the company can't help but be the real basis for the market value of the share. The market value of a share tends to bob up and down around the true value - the graph below might make this clearer. 

Imagine a company that experiences fairly steady growth year on year - sometimes it may grow a bit faster, and sometimes it may grow a bit slower. The growth of this company is represented by the smoothly increasing blue graph. The green graph shows what the share price might be on the stock market at any moment. In the long run it tracks the blue graph fairly well. This means that when you come right down to it in the long run, the market does actually care about the actual value of the company - otherwise there would be no correlation between the actual share price and the market share price. I've annotated the same graph below.

Now, I need to come clean. What I've told you so far isn't strictly accurate for a single company. It's much better if we think of the above scenario and graphs as representative of the stock market as a whole (the set of all publicly listed companies). So why is the above a little naive as far a single company goes? Well, although in the long run the market value might care about the true value of the company in the short term the market might not yet know the true value of the company. For example (Graph A below) hype could drive up the market value of the company in the short term. Meanwhile, the company itself may be in turmoil (the CEO is resigning, the storehouse burned down and the insurance hadn't been paid...). Sometimes the market just can't catch on fast enough until it's too late. The share's true value might hit zero in an extreme case and the market value will hit zero too. It is definitely possible to lose everything when investing in a single company. 

As another illustration, Graph B shows how volatile the market value for a single company (or even a single sector of the economy) can be. Graph C shows volatility, but over a large number of companies across different sectors of the economy the volatility is lower and the ride less bumpy. This is the reason why it is good to be diversified. Overall risk is lowered and the ride is smoother as well. 

So we don't ever invest in a single company. We want to invest in lots of companies. But there are costs involved in buying and selling individual shares. Plus how many of each company should we buy?

In the next post we'll look at Mutual Funds (aka Unit Trusts) as well as Index Funds to see how we can achieve this diversification easily. These investments products are ultimately invested in shares (lots of shares in lots of companies) so it's important that you're comfortable with what a share actually is. Hopefully this post has helped give you sufficient detail as well as the bigger picture.


Yours frugally
Mr Cent(ri)Frugal Force

Ethical Decisions: Avoiding the Fool's Choice

We recently stumbled across a website called Made in a Free World. This is about sourcing ethical products, ones which don't make use of what is essentially modern slave labour. They have an alarming survey called Slavery Footprint.

You fill in data about your lifestyle (in great detail, like how many rooms your house has, and how many pairs of pants you have!), and they work out how many slaves/indentured labourers work somewhere in the world to make that lifestyle possible. Obviously things like cotton, coffee, cosmetics and so on are really problematic. Electronic devices also seem to be a real problem.

The two of us got 26 and 35 slaves respectively.

This was scary.

This is the number of people - including children - who work in conditions that I'm sure all of us would consider unacceptable in order to provide us with our insanely luxurious lifestyles.

The economic chains which keep people in slavery are just as real as these ones.
Photo credit:Trevor Leyenhorst (CC-BY 2.0)

I recommend everyone does this survey. Rethink your life choices. It's a humbling exercise, and one which we should all do once in a while.

Avoiding the Fool's Choice

Now I know that often ethical consumer choices are prohibitively expensive. So how can we save money but still consume ethically?

This can be an example of a Fool's Choice or false dichotomy. You feel like you have to choose between two bad options. Actually, there is often a third option.

False dichotomy: forgetting the third option.
Photo credit: Dan Moyle (CC-BY 2.0)

Neither.

Don't buy the dodgy product. And if you can't afford the good product, then buy nothing.

Mostly, you don't actually need either of them.

Consuming less is a good idea anyway. Buying less saves money, cuts down on slaves and is also better for the environment.

When there isn't a third option...

Even food, the obvious exception to just not buying anything ever, can be part of the false dichotomy. Maybe the third option there isn't so much "neither" as "something else altogether", such local, in season fresh products.

But nonetheless, we have to accept that sometimes there is a genuine payoff here, and we have to make a genuine choice between cheapest and ethically acceptable.

This is a complicated, entangled issue. In each of these situations we need to make a moral choice as best we can. All I ask - and I am asking myself as much as I am asking you - is that we really think about the choice, rather than just grabbing the quickest, easiest, or even just cheapest option.

Think first. Consume later.
Photo credit: Taymaz Valley  (CC-BY 2.0)

Yours, in a most challenged frame of mine,
jjdaydream

Types of investment growth

A few months ago my wife asked me to explain to her the difference between interest, dividends and capital appreciation. If we add in income then these are essentially the different ways in which money in an investment can grow. I'll admit that up until now I've probably been a little vague about the distinction between these different mechanisms of growth so I'll try to rectify that in this post. 

In the long run, all these forms of growth kind of end up doing the same thing - they all grow your money. And if we draw graphs of investments that experience these different mechanisms of growth then the graphs would look exponential:

These are the same graphs that are produced by the "compound interest" formula that we looked at in an earlier post. 

All types of growth can look a lot like a lot like compound interest and they behave a lot like compound interest as well. Money grows at a certain rate per year and in subsequent years you get growth on growth. Compound interest is just a specific type of compound growth.

So if everything kind of looks the same and does the same thing then why is it important to make the distinction between these different mechanisms of growth? Why don't we just call everything interest and be done with it? Two reasons:

1. The "rates of growth" typically associated with each mechanism of growth can be very different. So some mechanisms will act faster on your money than others.
2. The different growth mechanisms are taxed differently. You need to know how they are taxed so that (a) you can invest in a tax-efficient manner and (b) you know how and where to declare the proceeds of your different investment growth mechanisms (the return on your investment) in your annual tax return.

These growth mechanisms are what cause the Financial Independence Engine to run and they cause it to run in slightly different ways.

Without further delay let's develop a rather silly analogy that will serve to illustrate the distinction between the different mechanisms of growth.

Edgar is the owner of a bakery that specialises in baking with interesting varieties and sizes of eggs - quail (small), duck (medium) and ostrich (large!). 

Photos used in the above image (left to right) credited to:
Roberto Verzo, snowpea&bokchoi and Beck (all CC-BY 2.0).

When Edgar does a stock take to see if he has enough eggs to cater for a large retirement party he doesn't worry about how many of each type of egg he has - he is only concerned about the total amount of eggy goodness he has (the rich golden yolk in particular). Quail eggs are the smallest with less yolk per egg, next come duck eggs and lastly the ostrich eggs with lots of yolk per egg.

In our analogy, the amount of eggy goodness or the yolk represents the rand and cents value of our investment. The different types of egg represent a single "unit" of an investment - for example a "unit" in a unit trust, a single share in a company or a gift card.

Egg yolk is the currency in this eggsample :-)
Photo credit Emilian Robert Vicol (CC-BY 2.0)

Let's continue...

It turns out that Edgar has more than enough egg yolk for the retirement party that he needs to cater for. In fact, he has so much extra egg yolk he's able to lend it out (in the form of eggs) to some of his friends who are also in the exotic egg catering business. In return for lending out egg to his friends in need, they will return the amount of yolk that they borrowed plus they will give him some more (either in the form off egg yolk or in the form of eggs). Let's look at these different business dealings in turn.

Edgar earns interest from Alice
For every litre of egg yolk that Alice borrows from Edgar she promises to give him back the original amount of egg yolk plus 10% extra at the end of the year. On 1 January Alice borrows 20 litres of egg yolk. After a successful year in business Alice returns to Edgar on 31 December and gives Edgar 22 litres of egg yolk: 20 litres being the original amount borrowed and 2 litres (10% of 20 litres) being the interest. Edgar now has more egg yolk than he started the year with; his investment has grown.

Edgar receives dividends from Bob
Edgar thinks Bob's Egcellent Eggs, is a great company to invest in and he invests 100 duck eggs in Bob's company. When the company makes a profit, Bob likes to give all the profit to his shareholders - these company profits distributed to shareholders are called dividends. After a great year of business Bob pays Edgar a dividend of one litre of egg yolk. At this stage Edgar could take his egg yolk and make himself a decadent and fancy omelette. But seeing as he's not retired yet, Edgar does best to reinvest his dividends. One litre of egg yolk is roughly the amount of egg yolk in 10 duck eggs so Edgar gives Bob another 10 duck eggs bringing up the total of his investment to 110 duck eggs with a value of 11 litres of egg yolk. 

Edgar earns capital appreciation through Cathy
Edgar decides on a long term investment in Cathy's Egg Emporium. He lends her 10 duck egg in January 2000. Cathy is incredibly focused on growing her company. If the company makes any profits, she pours them straight back into the company instead of paying it to the shareholders. So although the shareholders don't get any benefit immediately, they own a share of something that is worth more and their investment has grown. In December 2024 Cathy gives Edgar 10 ostrich eggs. How many eggs did Edgar have in 2000? Ten. How many eggs does he have now? Ten. So Edgar has the same number of eggs, each egg is just worth a lot more (in terms of yolk). This is capital appreciation. With capital appreciation you own the same thing (such as a house) or the same number of things (such as shares in a company), but each thing you own is simply worth more.

Edgar earns (rental) income from Dave
Dave runs a fancy coffee shop frequented by tourists and he thinks having some ostrich eggs on display in the window would be just grand! 

Photo credit: Redmond (CC-BY 2.0)

He arranges with Edgar to rent 20 ostrich eggs, in return Dave will give Edgar 2 litres of egg yolk (from chicken eggs from the coffee shop kitchen) per year. Assuming that an ostrich egg holds 1 litre of egg yolk, Edgar has received a 10% return on investment (eggs with 20 litres of yolk rented out and returning 2 litres in rental income).

Cracking open the analogy

Interest and income
When your investment grows through interest you get more units, but each unit has the same value (each rand is worth one rand, but you have more of them). Interest gets paid to you regularly.

When your investment grows through income you also get more units and each unit has the same value. You also get paid regularly. So income can look a lot like interest. So what's the difference? Consider the example of Alice who paid interest on the borrowed egg yolk and Dave who rented the ostrich eggs from Edgar. The only difference is the form of the asset that was borrowed. Dave was borrowing something that was not egg yolk itself (ostrich eggs) but had a value in terms of egg yolk and he needed to pay rental to enjoy the privilege. Alice was borrowing a certain amount of yolk (which is equivalent to cash in this analogy) and she needed to pay interest for this privilege.

Dividends and capital appreciation
Bob and Cathy represent two extreme ends of the spectrum of how companies decide what to do with their profit. Many companies will pay some of the profits out as dividends to shareholders and retain some of the profits for furthering future growth. When Edgar earned dividends he earned it in the form of egg yolk (the cash currency in this analogy). He then had the option of keeping his dividends or reinvesting by buying more shares of Bob's company (measured in terms of duck eggs in this case). By reinvesting he increases the value of his investment because he has more shares, not because the shares he has are actually worth more. From Cathy, Edgar received no dividends and no intermediate payments. By retaining all the company's profits Cathy was making each share of Bob's more valuable. After 24 years Edgar's 10 eggs invested in Cathy's company were so valuable that he needed to receive ostrich eggs when we cashed in on his investment. In this example he had the same number of units of investment, but each one was worth more.

Remember that interest only barely keeps up with inflation (sometimes it doesn't even do that) so although it's useful it should not be your primary source of investment growth.

When you invest in companies through unit trusts, ETFs (Exchange Traded Funds) or actual shares you'll benefit from both dividend income as well as capital appreciation in the long term. Some companies pay out more dividends than others and there are unit trusts and ETFs that try to have a higher proportion of high dividend paying companies.

Rental income is useful (but see the tax implication below) and an easy way to have some exposure to it is through unit trusts or ETFs focussing on owning and renting property. You'll also get some capital appreciation through these unit trusts or ETFs as the values of the properties rise over time.

Tax implications

You can earn R23 800 worth of interest in a single tax year before you start paying tax on interest earned. You'll need to declare all interest earned from all your investments. You can get this amount by adding up all the amounts labelled "local interest" on the IT3(b) statements that you'll get from your financial management people and banks.

Dividends that you earn are taxed in the hands of the company before they are paid over to you. You'll need to declare all dividends earned in the "other non-taxable income" category on your tax return (and follow the same approach of adding up all the dividend amounts on your IT3(b) statements.

From year to year you'll probably not need to worry about tax on captial appreciation. This is because you'll only pay tax in the year that your investments are sold. This will (hopefully!) result in a large capital gain which follows the rules of Capital Gains Tax as described in the post on tax.

Investment income (such as rental income in the above example) is taxed in the exact same way as your regular income from your job. The full amount is included in your taxable income (no exemptions like interest income or the same benign treatment as capital gains tax)

A fifth way of growing your money!

The four mechanisms of growth that we've discussed so far are not the only ways to grow your investment. You can also manually put money in yourself! This is money that you have saved for the purposes of investment. It's the fuel required for the Financial Independence Engine before it starts running itself. 

In the short term, the amount that you are able to put in will far outstrip the investment returns from any of these types of growth. But eventually these growth mechanisms (the backbone behind Pillar Two) will start to earn more than you possibly can. The huge advantage of the investment growth mechanisms discussed in this post is that they are a type of passive income - meaning you don't have to work once they've started out earning you - this is the stage at which you've earned your financial independence.

The relationship between investing and borrowing

You might have noticed that depending on how you read the examples of Alice, Bob, Cathy and Dave they could sound a lot like credit and borrowing. Yikes! How did an example about an investment start to sound like an example about borrowing? Investing (or lending as in the example above) goes hand in hand with borrowing. When you invest in some investment product or company they are essentially borrowing money from you. From Edgar's perspective he's investing. From Alice's perspective, she's borrowing (as long as she's borrowing in order to expand her business, that's fine - as long as she doesn't start funding a decadent lifestyle on egg yolk credit!).

In a post that I hope to write soon we'll look at the different options of where to invest in South Africa. In the meantime I hope you've found this post useful!

Pillar 2: The Financial Independence Engine

Pillar 2: The Financial Independence Engine

(aka sensible investments)

Recall that the second pillar upon which a financially independent life is based is choosing sensible investments which will grow faster than inflation. You need to choose investments that give the biggest possible rate of growth (i in the compound interest formula). In this post I hope to give some background to the options available to you.

Our Financial Independence Engine. Next stop, "Freedom!" Choo Tjoe!
Photo credit State Library of Queensland (no known copyright restrictions)

Saving vs Investing

Firstly, it's important to make a distinction between saving and investing.

Saving is a verb - it's what we do as we build up Pillar 1. We live a frugal lifestyle and the money that we're no longer spending on things we don't need we save. But once the money has been saved it has to be put somewhere.

Savings is a noun - it refers to our saved up cash.

Cash in a treasure chest may look pretty, but it's the Engine we are looking for.
Photo credit Tom Garnett (CC-BY 2.0)

 Now cash doesn't necessarily mean actual coins and notes. It can refer to something like a bank account, a fixed deposit or a money market fund: where your money is somewhere invested in actual coins and notes, and (some) of the interest on that is passed on to you. This is what we call a cash investment.  The thing about all of these cash investments is that they won't be working hard in the way that you need them to in order to build up Pillar 2. Even when you're earning interest on your cash (alarmingly NOT always the case in South African banks), this interest is usually in line with or lower than inflation.

Cash is not King
Cash is a Lazy Prince who is vulnerable to the Vampire of Inflation

Inflation is a Scary Vampire, but there is a way out!
Photo credit Enokson (CC-BY 2.0)

At some point I'll do a post all about inflation. For the moment, all you need to appreciate is that inflation is the rising price of goods and services as time progresses. Inflation is the reason that prices go up and why salaries need to have "cost of living" increases. Inflation has hovered around 6% in South Africa for the past few years and at the moment it's about 4,5% - so let's just simplify things and say we're dealing with an inflation rate of 5% (to see historic inflation rates click here). Now not all goods and services rise with inflation - some rise faster and some rise slower. But it's a good way to estimate the price you can expect to pay for something from one year to the next - something that costs R100 today will probably cost about R105 next year.

The problem, of course, is that although your cash is growing (hopefully) it isn't necessarily growing fast enough to counteract the effects of inflation. If you earn R3 in interest but the price of your groceries went up by R5, you've actually lost R2; even though you might have thought that your savings was growing!

If you are getting 3% in interest (since we're hoping to be earning on significantly more than R100), that isn't good enough - over the course of a year your savings will still get effectively smaller by 2%. Do this every year for 10 years? You've lost a lot of money. It's still more actual rands than you started with, but it can't even buy the same amount as you could at the beginning. You are further from financial freedom than ever.

If you don't want to lose out to inflation then you're left with a few options:

1. Spend your money now before the Vampire of Inflation sucks its value dry.
2. Invest your money in something that grows at the same rate of inflation.
3. Invest your money in something that grows faster than inflation. 

The first option seems attractive - spend now before prices go up next week. Logical, right? But with this approach all we're doing is spending, not saving. We'll never have our money working for us and growing with compound interest because we'll never have any money. So let's scrap this option immediately. It goes against Pillar 1 because it will leave us with no fuel for our financial independence engine (Pillar 2).

And who would choose the second option if they could choose the third option? So let's see how to achieve growth faster than inflation.

We need to save money and then once we've saved it we need to put it into a suitable investment. So far we've determined that this suitable investment is not cash under the mattress, a bank account, a fixed deposit or money market. So what's left?

The Stock Market

All evidence spells out "Stock Market" as our Engine of choice
Photo credit Simon Cunningham (CC-BY 2.0)

It's by investing in companies listed on the stock market that we'll get the inflation-beating returns we're looking for. But wait, aren't stocks "risky"? The short answer is No. The longer answer needs us to define what we mean by "risk". In the world of investing, risk is related to the probability that your investment will lose value. Okay, we probably agree on that definition. But how can I say that the stock market is not risky if a company that you're invested in can go bust and lose it's entire value?

Let's be clear at this point. It is entirely possible to lose money in the stock market if you invest in any of the following ways:

1. Investing for the short term. Investing now and expecting to cash in on your investment within a very short time period. At any particular moment your investment might experience a temporary (but possibly very large) dip in value despite the fact that it is growing overall. You don't want to be forced to withdraw it during the dip.
2. Investing in a small number of companies and tying the fate of your investment to those few companies. Those companies might die a horrible death, in which case your investment has gone down the tubes. Don't invest in a company based on "a hot tip" from a friend or because the media is going crazy about it.
3. Trying to time the market by "buying low and selling high". This is a nice idea in principle, but it's impossible to consistently get this timing right. Regular people are not soothsayers or stock market geniuses.

So how do we invest in the stock market and reduce the above risk?

1. Invest for the long term - minimum 10 years.
2. Invest in a large number of companies - this is called diversification. If one company goes bust you still have money in all the other companies working for you.
3. Don't try to time the market. Invest regularly and consistently. It's not about timing the market, it's about time in the market.

At this point I think it's really important that you get a decent level of understanding of the stock market before you start investing. One of the Overseas Masters, jlcollinsnh, has done a wonderfully readable explanation of investing in the stock market. He writes from the perspective of the US stock market, but most of what he says can be applied to the South African stock market as well.

We're nearly at the point where we can start looking at specific places to invest your money in South Africa. But it really is important for you to feel comfortable and confident when it comes to investing the money that you have saved through Pillar 1 - this is why all this background has had to come before the specifics.

Until next time!

Pillar 1: Fuelling the Financial Independence Engine

Pillar 1: Fuelling the Financial Independence Engine

(aka Living a Frugal Lifestyle)

Photo credit trophygeek (CC-BY 2.0)

The more you can reduce your expenses, the more you have available to save and put into investments. Eventually these investments will be out-earning you and will be generating enough growth on their own to fund your lifestyle. 

Reducing expenses is more important than increasing income because it does two important things:

1. It means you can save more.
2. It means the target you need to reach is smaller so you'll get there sooner.

The first point is (hopefully) obvious:

income - expenses = money to invest!

But by itself it does not explain why reducing your expenses is more important than increasing income when trying to increase the amount of money you have to invest. To explain that we need to look at the second point. Remember that your sizeable investment will be growing at a certain rate above inflation. If the amount by which your investment grows is greater than the amount required to live then you can consider yourself financially independent!

  growth on investment > living expenses

                                            ⇒

financial independence!

If you live a frugal lifestyle your living expenses will be lower. If your living expenses are lower the the growth you require on your investment will be lower. Which means you need a smaller total investment to produce that growth.

Think Creatively to Live a Big Frugal Lifestyle

Some people are naturally frugal. But frugality is definitely something that can be learned. It eventually becomes fun and natural. At first it requires you to look at all of your expenses and re-evaluate them. Think outside the box. Don't assume that every expense is a given and that there is no way around it. Yes, some of them might be (if possibly only temporary), but you should at least try to think of creative solutions around them.

Spend some time drawing up a list of all the things you spend money on and try to find ways to find cheaper alternatives. Some expenses could be deleted from your budget permanently! In future posts we'll look at some specific examples of how we've reduced our spending.

Yours frugally,
Mr Cent(ri)frugal Force

Introducing The Two Pillars and Compound Interest

Dear Awesome Person

In the last post I stated somewhat cryptically that:

"Money can be used to buy freedom by not spending it."

Photo credit Julia Maudlin (CC-BY 2.0)

It's probably time to explain what I meant by this. I present to you what I consider the two pillars upon which a financially independent life is based:

1. Live a frugal lifestyle so that you free up money that can be put to good use.

2. Find sensible investments where your money 
will work hard for you, and one day, will be able to work harder than you possibly can.

The sensible investments can be thought of as a Powerful Financial Independence Engine 
and the money that you save by living a frugal lifestyle it can be thought of as Fuel for the Financial Independence Engine.

But first we need to understand the inner workings of the machine which allows the engine to function:

The Power of Compound Interest

Compound interest will be a ridiculously powerful ally on your quest when it acts in your favour. But compound interest can be a double-edged sword. If you get on the wrong side of compound interest then the quest becomes exponentially* more difficult. (The wrong side of compound interest is a Fiendish Beast of the Night called Debt; we'll talk about this in a future post.)

When money is placed in an investment (we'll look at what types of investments there are and where to get them in a future post) then it grows according to the compound interest formula**:

F is the value of the investment, P is the money you put into the investment, i is the rate of growth and n is the amount of time you invest for.

The value of your investment is larger for larger values of P, i and n. This makes sense:

• the more you invest (P) the more your investment should be worth
• the faster your investment grows (i) the more it will be worth after a certain amount of time
• the longer you invest for (n) the more time you give compound interest to compound the growth on your investment

For now, let's look at a pretty amazing example of how the growth rate (i) and time (n) can work together to produce a snowball that starts small but eventually produces an avalanche of treasure.

If you can find an investment that produces real returns (returns above inflation) of 7% then an investment doubles approximately every 10 years. Using the compound interest formula we have:

What does this mean? Let's perform a thought experiment. Imagine that you have R100. I maintain that this is actually a lot of money and should be respected, but depending on your frame of reference it's not that much and shouldn't be too hard to find (chances are you have a R100 note in your wallet right now; go and fetch it and you don't need to imagine having one). Now imagine that you invest this R100 in an investment that grows at 7% per year above inflation. In ten years time you will have the grand total of... R200. Wow, that's a bit anti-climactic isn't it? Where is this phenomenally powerful engine that I promised? Be patient, the juggernaut is just getting going. 

• After 20 years you will have R400.
• After 30 years you will have R800.
• After 40 years you will have R1 600.
• After 50 years you will have R3 200.
• After 60 years you will have R6 400.
• After 70 years you will have R12 800.

"Okay", you might say. "That sounds like a lot of money, but it took 70 years to do that!" I'll be amongst the first to admit that 70 years is a long time to wait. But just think about what just happened. We took R100 and turned it into R12 800! This is an amount of money that could easily be spent on going to the movies, having take-aways or going out for an evening and you might not even notice spending it. But if you invested it instead of spending it, in 70 years you could have R12 800 to leave to your grandchildren as an inheritance or to donate to charity.

Let's be a bit more ambitious. Let's say we've managed to save up a small nest-egg of R10 000 that you were planning on putting towards something completely unnecessary like a new HD  TV or a fancier car. What does that become in 70 years?

R1 280 000 or R1,2 million.

Okay, that's a little more like it. But still, why am I talking about investing over 70 years if I'm trying to show you how you can use compound interest to achieve financial independence in a much shorter time frame like 10 years? It's because the interest rate (i) and time (n) are not the only factors that affect the final value of your investment. The amount you actually put in (P) has a profound affect on what you eventually get out. I needed to talk about periods of 70 years to give compound interest enough time to work because in our thought experiment we were not being ambitious enough. We were putting R100 or R10 000 away once off and then thinking that this is enough. Compound interest is powerful, but it won't achieve financial independence on its own. It needs something to compound on!

The general financial advice given when saving for retirement is "save 10 to 15% of your income and you'll be fine". Only saving 10 to 15% is what means you'll be working until you're 65. You're not letting P (what you put in) do enough work in the compound interest formula, so n (time) has to make up for it.

If we have a certain target, which will allow us to be financially independent (and we can talk about how to decide on this target in a future post), this is your F. So how do we reach this target?

Start investing now.

This makes n large in the compound interest formula giving compound interest more time to do its thing. Since we want n to be as small as possible for our target F (hello EARLY retirement), we need to increase P and i as much as possible. But of course, we should also start the process as soon as possible so that we maximise n without selling ourselves to work forever.

Invest as much as you can. 

This increases P in the compound interest formula. Increasing the amount invested comes from living a frugal lifestyle so that expenses are reduced and that there is more money to invest. This forms Pillar 1, which we'll talk about in more detail next time. It sounds so simple but there is a lot to it!

Increase your rate of growth

Invest in something sensible that will give you as large a growth rate as possible over the long term. This increases i in the compound interest formula. Increasing the rate at which your investment grows by choosing the right investments and investment platforms makes up Pillar 2: this requires a lot of thought and research as there are loads of pitfalls along the way.

Making use of the mathematics behind the power of compound interest will have you saving hard initially in order to increase P. Then once you've reached financial independence you can simply let i and n take over. That's freedom. Your money works so you don't have to.

Mr Cent(ri)Frugal Force


* Literally. Compound interest (on investments or debts) is an exponential function. Mathematically powerful to say the least.

** For multiple investments of different sizes made after time intervals of different length and with varying rates, the formula is a lot more complicated, but the factors that affect the final value of an investment are the same: P, i and n - it's just that none of these are constant.