Chapter 3 - How to invest

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Intro

This chapter will guide you through the investment process. Step-by-step. By the end of it, you will know what vehicle you should invest in, the type of investment and the platform you will be using.

Shu. That sounds complicated. But don’t worry. Have you ever played the game “Pick a Door”? It is easy & fun. Anyone is able to play. The great thing about this game is that by the end of it, you will know how to invest for your child’s education. Drum roll, please.

The “Pick a Door” Game

There are three levels in total. At each level, I will present you with three doors to choose from. But don’t worry, you have a number of helpful “lifelines”, which I will give you. This will allow you to pick the right door for you.

Level #1 - Choose your Investment Vehicle

  • Door 1: Normal Taxable Investment Account
  • Door 2: Tax Free Savings Account
  • Door 3: Endowments

Welcome to Level 1. You have three doors to choose from.

Door 1 is a normal investment account. Choose this door and you will be taxed on income and any capital gains this account will produce. Nothing fancy here. Just a stock standard boring door.

Door 2 is a Tax-Free Savings Account (TFSA). A TFSA is a great savings vehicle introduced by our government to encourage savings. What makes it so enticing is that all income and capital gains produced within this account are tax-free. Tax-Free! That is a big deal. Unfortunately, there is a limit to how much you can contribute. The limits currently stand at R33 000 per year and a lifetime contribution limit of R 500 000. Crucially, you are unable to subtract your withdrawals from your previous contributions. For example, if you have contributed R 33 000 the one year and have withdrawn R 30 000 the next year, your total contributions still stand at R 33 000! These limits are an important consideration when choosing the right door.

Door 3 is an endowment. An endowment is a tax-efficient vehicle for high-income earners. Specifically, for those citizens with a marginal tax rate above 30%. If you go through this door, you are liable for a fixed 30% income tax rate. However, an endowment comes with a restriction period. During the first five years, you may only make one withdrawal. After the restriction period, you are allowed to withdraw at any time or make regular withdrawals.

So which door is right for you?

Before you choose, I present you with the “audience lifeline”. This helpful “lifeline” will tell you what is most appropriate for most audiences. Here it is: For the purpose of an education fund, in 99% of cases, the appropriate vehicle is a normal taxable investment account. That is door number 1.

Door number 2 should be opened with caution when it comes to using it for your children’s education fund. There is no doubt that you should - let me rephrase MUST - open a tax free savings account. However, they are more ideally suited for retirement. Since your lifetime contributions are limited to this vehicle, you could run the risk of depleting this valuable savings vehicle to pay for your children’s university if you are not careful. Some advocate the use of such a vehicle to merely supplement their children’s tertiary education. That is a viable option. For me and the majority of people, this is simply too complicated. I like to keep things simple. That is, I like to keep my goals separate and use a TFSA for retirement purposes and a normal investment account (door number 1) for education purposes.

Door number 3 should only be opened if you fall into a tax bracket higher than 30% and are happy with a restriction period of five years. Additionally, there are investment limits applicable. If you invest more than 120% of the higher of either the previous two years total contributions, your restriction period is extended by another five years. I know. But that’s not all. Majority of endowments are offered by life insurance companies and attract some ridiculous fees. Choose door #3 carefully and tread with caution once opened given the rules put in place.

Level #2 - Choose your Type of Investment

Congratulations, you have made it to level 2. With level 1 out of the way, it is time to choose your type of investment. You are again presented with three doors.

  • Door 1: Personally Managed Share Portfolio
  • Door 2: Actively managed fund
  • Door 3: Passive investment

Door 1 is a personally managed share portfolio. Choose this door and you will get to research, select and buy your own shares.

Door 2 is where you hand over the keys to a professional and let them make the decision of which companies to buy and sell in your education portfolio. Alan Gray, Coronation or Prudential are an example of active managers.

Door 3 is a passive investment. Unlike active managers, who pick the investments they think will outperform, a passive investment is well passive. Investments are made according to a set of pre-determined rules. Invest in the top 40 companies on the JSE according to their market size. An example would be the Satrix Top 40 fund. Another is the Satrix MSCI World Feeder Fund. This one gives you broad, diversified exposure to the world's companies. Passive investments give you broad diversified exposure at a low-cost.

So which door is right for you?

Lets use another joker. Lets call a friend. An expert friend. A friend who has done some hectic research in this area. We will call him.

Ring. Ring.

"Hello. This is Mr Research speaking."

"Mr Research. This is the Pick-A-Door Game. I have three doors here relating to 'Which type of investment is right for you?'. Door 1 is a personally managed share portfolio. Door 2 is an active investment and the last door is a passive investment. Can you help our contestant?"

"Well. Luckily, I have spent years researching this very question. And the answer is clear from a scientific point of view. All the research points to door 3. Door 1 & 2 will underperform Door 3 more than 90% of the time. But note that door 3 - the door to passive investments - is not a popular choice. If you were to ask the audience, I venture that a large part would still vote for Door 1 or 2 despite what the evidence suggests. "

Level #3 - Choose your Platform and Investment

Hooray. You have made it to Level 3. Depending on which door you chose, you

This chapter is still in progress...