Asset Classes / Allocation
What is Asset allocation?
Asset allocation is the spreading or distributing of your assets between different categories to spread your risk, and enhance your returns.
There are generally three broad asset classes or categories in which you can invest your money.
- Cash or Money Market Funds
- Fixed Income (Bonds)
- Equities (Shares)
Cash and/or Money Market funds
Money Market Funds consist of individuals' money pooled together in various short-term money market instruments, (same as your fixed deposit) managed by a professional. Short-term money market instruments are not allowed to exceed 1 year. [You, however, can leave your money in the fund for as long as you like, but the fund will be investing in instruments of less than 1 year.]
Market funds have become the investment of choice for those wanting to preserve their capital and receive a competitive interest rate. Furthermore, money markets allow you access to your capital just like the traditional call account would.
With the relaxation of exchange controls by the South African Government, investors now have the added choice, and problem, of not only investing in South African cash, but also USD, Sterling or Euro cash. Traditionally the most important aspect that determined a currencies strength was the level of interest rates. These days it is a lot more complex. This is largely due to the unprecedented speculation by corporations, hedge funds and individuals in the exchange markets.
In money market funds you thus have an extremely low risk investment - hopefully outperforming any savings or fixed deposit you made in a simple bank account. The professional money manager's job consists of constantly looking to get you the best return in cash. Both your advisor and the fund will charge you a fee for such active management, and you need to take these into account if you plan to leave your money in cash indefinitely.
Investors often believe that cash is a risk free investment. Cash deposits, however, are at risk to inflation. If you are receiving less interest than the rate of inflation in any country then your deposit is going backwards in real terms.
Fixed Income (Bonds)
A bond may be described as a tradable debt instrument that is issued by either a government or a corporation. Below is an extremely simple rendition of how bonds work.
Secure Capital decides they need R500,000.00 to expand their business. We send our clients an email asking them to lend us the money - subject to certain predetermined conditions of course. We will pay a fixed rate of interest (fixed income) of 20% per annum over a 5-year period with the R500,000 payable to the investors at the end of the term. Five of our clients take us up on the offer because they believe we are creditworthy and trustworthy. We now have a loan paying our clients 20% per year. And if all goes well then our clients will receive the 20% per annum, and their capital back at the end of the 5 year term. We issue them with a loan certificate outlining the details of the loan/agreement.
Our clients can now sell their certificate (bond) to another person or institution if they want to. The bond certificate is therefore tradable. It is a money market instrument that can be exchanged between two parties.
Where are the risks?
- Secure Capital can go out of business and default on the loan. Our clients will then have to stand in the queue to try and salvage some of their capital back.
- Interest rates can go up. If interest rates go up to 30% our clients would be better off having their R500,000 in the bank. No risk and a better return. If I now want to sell my bond to someone else I will have to offer them a discount, as they too would rather get the current 30% than receive a fixed 20% from Secure Capital.
- Inflation might spike. Central banks generally hike interest rates in an inflationary environment and as you saw in the previous paragraph this is normally not good for bonds.
Why invest in Bonds?
- If our clients' judgement is sound, and Secure Capital is creditworthy, our clients have an investment paying them a fixed return over 5 years with their capital repaid to them at the end of the 5-year term.
- Interest rates can go down. If interest rates went to 10% our clients are better off as they are still receiving 20%. If they now sold the bond they hold with Secure Capital onto another party, they could now command a premium on their investment as they can only get 10% at the bank.
- Bonds are less risky than shares because interest is paid out of company profits before dividends and if Secure Capital goes into liquidation, bondholders are repaid before shareholders.
- They generally produce higher returns than cash over the medium-long term. The risk has to be taken into account however.
All bonds are rated by credit rating agencies like Moody's or Standard and Poors. This allows investors to ascertain whether they are a sound credit risk. AAA is the highest rating a bond can get - the risk of default is negligible. The SA Government is presently rated BBB - subject to change.
Government Bonds are more secure than corporate (company) bonds. It stands to reason that the US government bonds (tradable loans issued by the US Government and guaranteed by the US taxpayer) are more secure than Amazon.com bonds. The chances of the US Government defaulting are a lot less than Amazon.com. Investors can demand a higher interest rate from Amazon than the US government because of the higher risk.
Another crucial aspect to investing in bonds is the duration of the bond. It is generally accepted that the longer the bond the greater the risk.
To conclude you must determine the level of risk when investing in individual bonds or a diversified bond fund.
Equities or Shares
This is where it really starts to get interesting and a lot more risky. Your returns however are greater over the long-term than the previous two options. Shares are also called equities because the term equity means the value of the company after all liabilities (debts) and other obligations have been discharged [paid back].
Brief History of the Markets
Stock markets first developed in the 17th and 18th centuries in the great international trading centers such as England and the Netherlands. Investors would provide risk capital to the great explorers of that time in exchange for a share in the profits of the venture. It is no surprise that the earliest Exchanges were therefore London and Amsterdam. The New York Stock Exchange [NYSE] started in the late 18th century.
The largest Stock Exchanges in the world are the New York Stock Exchange (NYSE), London Stock Exchange (LSE), and Tokyo Stock Exchange (TSE). The Nasdaq is the electronic exchange based in New York. The Nasdaq attracts a lot of growth companies or smaller companies, as the listing requirements are less stringent than the major indices.
Stock Exchanges provide:
- A mechanism for companies and governments to raise money, known as the Primary Market.
- Provide a means for investors like us to buy and sell shares or other financial instruments that have already been issued. This is known as the Secondary Market.
An Index provides a measurement of the performance of the Stock Market or a basket of shares. They also provide you the investor with a benchmark to track the performance of your own portfolio.
The best-known Index is the Dow Jones Industrial Average. It consists of 30 shares. Recognizable shares in this Index are Boeing, General Electric, McDonalds, Coca Cola, Intel and Microsoft. Other well-known indices are:
Nasdaq 100: Top 100 shares on the Nasdaq. Microsoft and Intel are examples of companies listed on both the Nasdaq and the Dow Jones Industrial Average.
S&P 500: The top 500 shares in America.
FTSE 100: The top 100 shares in Britain.
Nikkei: 225 shares make up this index in Japan.
The Dax 30 and the Cac 40 are the German and French indices respectively.
Alsi 40: The top 40 shares in South Africa by market capitilization.
Sources of Capital for a Company
In the previous tutorial on Bonds we mentioned that Secure Capital could raise capital (borrow money) by virtue of a bond to finance the company growth. Another method Secure Capital could follow [if we met certain strict listing criteria] would be to list on a regulated stock market. Thus companies obtain their capital from 2 sources:
- Borrowing (bonds, bank loans, overdrafts, etc.)
Types of Shares
- Ordinary Shares
- Preference Shares
- Deferred Shares
Every company has ordinary shares. The ordinary shareholders are the true owners of the company who are entitled to the balance of the income of the company after all expenses have been paid. Investors like you and us would buy ordinary shares on the stock market. Ordinary shares are also called equity shares or equities.
Why does an investor want to invest in shares?
A shareholder has the right to share in the profits of the company by way of a cash payment called a dividend. The amount of the dividend depends on the level of profits. If profits increase from one year to the next, then so should the dividend. By investing in shares you should receive an increasing income as the company becomes more successful. Over and above that dividend income - as the company grows so does the value of the shares, thus offering the prospect of capital growth. This is the principle reason why investors are attracted to stock markets.
Unfortunately investors often lose sight of the above basic principles and invest in shares only for capital growth. The Nasdaq in America is a prime example of this phenomenon. Most of the shares, which were hammered in 2001, were not making any profits at all.
Who invests in shares?
Private investors like you and us who hold shares solely for their own benefit. Corporate Investors companies that hold shares in another company solely for their own benefit.
- Pension funds
- Insurance companies
- Mutual funds (Unit Trusts are called Mutual Funds overseas)
Many private investors do not have the knowledge or resources to hold a portfolio of shares directly so instead invest through a Unit Trust or Mutual Fund. The advantages of investing through a Mutual Fund are:
- You participate in a diversified portfolio
- Professional management of that portfolio
How do you choose a Fund or a Share?
The first thing you should do when purchasing a new share or a Mutual Fund is ask for a Prospectus. This is a formal document outlining the structure and fees and other details of your share or investment. You are ultimately responsible for your own money and it is no use crying foul if you did not do your homework thoroughly.
The Prospectus should give you the Funds mandate. This is essential in determining what the Professional managing the fund can and cannot do. If you choose a conservative or balanced approach the manager has to operate within his mandate.
Besides the Prospectus there are numerous figures which investors consider in assessing the companies. We are going to concentrate on just two of them.
Price Earnings Ratio: [PE Ratio]
A really long-term investor will fare better if he selects stocks with low price earnings ratios, if all other factors are equal. (Sir John Templeton-December 1953)
The PE Ratio can be regarded as the number of years worth of profit an investor is prepared to pay in order to buy a share in the company.
The price earnings ratio is defined as the Market price of a share divided by the earnings per share. If Liberty Life share price is R70.00 and their profit after tax (earnings per share) is R7.00 then their PE is 10. Simply put you should recoup the value of your investment in ten years through the distribution of profits (dividends).
Find out or ask your advisor for a recent breakdown of the shares in the fund and the average PE of the Fund before investing in the fund. Choose funds or shares with low P/E's if you are a truly a long-term investor.
The yield on a share is defined as:
Dividend per share divided by the current market price per share x 100%. If you have a dividend of R1.00 per share and the price of the share is R20.00 the dividend yield is 5%. Only the strongest and well-established companies would have a dividend yield of 5%. This type of share would appeal to a conservative investor.
When purchasing shares or a Unit Trust ask for the average P/E of the fund and its historical dividend declarations. They will go a long way to telling you what type of investment you are about to make.