Question:
What is the safest way to invest a lump sum?

I need to keep the capital safe and use the monthly interest to live on. This money is going to be my only source of income.

Answer:
After all the action we’ve seen on local and international markets over the last few weeks, I can certainly understand why wanting to keep your capital safe is such a great concern for you. It is, however, important to consider that 'safe' can mean different things depending on what you are trying to achieve. When we think of risk, we tend to view it as our chance of losing money. Although this is true, exactly what this means is often not as clear.

The form of risk that most of us fear can be referred to as volatility risk. This means that the value of your investment goes up and down with market movements, meaning your portfolio could be worth less tomorrow than today. Shares, also referred to as equities, are the main source of volatility in most portfolios.

On the other side of the scale we have cash, in which we mainly invest in the form of fixed deposits, money market funds and savings accounts. Unlike shares, property or some other investments where we mainly make money because of capital growth (i.e. the values go up), cash pays us an interest rate that is earned and taxed as income.

So, why shouldn’t we put all our money in cash if it essentially guarantees we'll never be losing capital? This brings us to another type of risk — inflation risk. Over the last 20 years, cash has given us a return of about 3.6 percent above inflation before tax. This means that for every R100 000 we invest, we will be able to draw an income of R3600 per year (or R300 per month) if we want it to keep pace with inflation. If we draw all the interest we are earning, the value of our R100 000 will become less every year in line with inflation.

Alternatively, you can decide to draw all your interest every year. At an average inflation rate of say eight percent, the value of your money in today’s terms will halve every nine years. This means that a 65-year-old earning R10 000 interest per year will be earning roughly R1250 (or R104 per month) by the time they reach age 92. This is particularly scary if you consider that this will be the age where you will most likely need an income for medical expenses, nursing care and other frail age expenses.

To make matters even worse, the interest income we receive that is over R19 000 per year (or R27 500 if you’re over 65) is taxed in our hands, reducing the actual income we earn even more.

Shares, on the other hand, achieve almost the opposite. Unlike cash, they give us a very real chance of suffering short-term losses. From 1900 to 2000, shares produced a negative return roughly one out of every three years. So why invest in them? Because over time, there is no better bet if you want to outperform inflation by as much as possible — over the last 20 years it’s been by about 8.4 percent.

Time also has a wonderful way of reducing our risk of losing money in shares. Where I historically have a two in three chance of making money in shares over one year, my chance increases to 95 percent over five years and 100 percent over periods of 10 years and longer. If you consider that your retirement investment will probably need to stick around for at least 25 years, it stands to reason that not only will you be able to draw a greater income if you have more share exposure, but you will also have a very slim chance of losing money over time if you can keep your emotions in check for the first five years.

So what are the lessons you can take from this?

1. If you are going to invest your money in cash, you will need to draw a relatively low income and will have a very real chance of losing money against inflation.

2. If you want a higher income over time, you will need to expose yourself to asset classes like shares, properties and bonds for extra growth.

3. Your major chance of losing money in the above asset classes is in the first five years of investment.

4. If you need money over the next year or two, leaving that in cash is mostly a good idea. But after a point, you will need to accept that the market is your best bet. Just remember to measure your growth on what you invested originally, not on what it was worth last year!

Although there is no perfect answer, these tips should stand you in good stead to find a solution you’re most comfortable with. Good luck.

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