The world is changing fast and to keep up you need local knowledge with global context.
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By Maria Smit*
While many of us dream of becoming an investment whiz able to read the markets and pounce on winning ideas all the time, that is far from reality. The truth is that unless you can dedicate hours to research and analysis and know what you’re doing, then taking a wild punt on the markets is as useful as playing the lotto.
But just because you don’t have time to dabble in some day-trading doesn’t mean you have to stay ignorant about key investing principles and concepts. Prudent investors appreciate the value of a financial advisor, but wise investors recognise the value of understanding what the advisor is talking about.
So, here is a broad-brushstrokes introduction to key investment terms, what they mean and the role they play in your portfolio.
Different asset classes offer different benefits
The central idea in investing is to buy something that is going to appreciate in value so that your money is worth more in the future. That ‘something’ is typically an investment that has a clear and measurable value.
Although there’s a wide variety of investment assets you can buy into, most portfolios are made up of three main asset classes – each of which has pros and cons. Which is precisely what you want if your aim is to build a portfolio containing a variety of assets so that you don’t sit with all your eggs in one basket.
Equities is another name for stocks, or shares if you like, that are listed on a publicly traded exchange like the JSE or New York Stock Exchange, Nasdaq or London Stock Exchange.
When you buy shares in a company, you get equity (aka ownership) in that company, with the aim of selling those shares at a later date at a higher price. That promise of a big payday is the appeal of equities, but the big payday is anything but guaranteed. Equities are your riskiest asset class because a future return is never guaranteed, although history shows that over the long term (certainly 20 years and more) the value of your asset will have increased.
A bond is a different type of investment asset that is, in plain terms, very much like an IOU from large companies or governments. They use this mechanism to raise debt because it might be cheaper than going to traditional lenders for capital.
The advantage to you as an investor is that you can buy a bond with a maturity date of anything from 1 to 10 or even 30 years (for some government bonds). In return for investing your money for a fixed period, you will receive your original capital back at the end of the period, while receiving a return every quarter, half-year or year. That return is known as the bond yield, which tends to be higher than returns you get on most savings accounts, cash or money market accounts.
They play an important role in your portfolio because they’re less volatile than stocks, and therefore less risky. Also, bond yields usually rise when stock prices fall, which adds a further layer of protection to your portfolio against outright loss if markets fall.
Cash or Money Market
Cash doesn’t necessarily mean notes and coins in your wallet, but rather it’s money stored in your bank accounts or short-term investments, like a money market account.
Although cash is considered a safe investment because you’re no poorer if the stock market crashes, you will be poorer if the value of your money doesn’t keep pace with inflation. That is the role that a money market account plays because returns are usually in line with, if not slightly above inflation, but without the risk.
Understanding these different risk profiles helps you to understand how you can diversify your risk by investing in a mix of different asset classes.
Diversification is the cornerstone of investment theory as it has proven over time to be the best defence against the uncertainty of what the future holds. If you’d been invested 100% in equities when the market crashed in March 2020, you would have been far more stressed than someone with partial exposure to equities, bonds, cash and money market investments.
One other way to diversify your risk is to buy investments in other countries. You can do so easily today without having to do foreign exchange transactions when you invest in rand-denominated global equity funds[JB1] . This spreads your risk because your fortunes aren’t tied only to what’s happening domestically.
South Africans don’t need much of an introduction to the cost of living crisis the rest of the world is now experiencing as inflation spikes around the globe. Rising prices, from electricity to food to fuel, decrease your buying power.
For investors, the threat is that your future buying power will also be greatly diminished if your investments don’t grow at a faster rate than inflation. We all know that a R1,000 today buys a lot less at the grocery till than it did five years ago. Just imagine how much, or little, that amount will buy you when you retire in five, 10 or 20 years from now.
The only way to stay ahead of the curve is to have an investment portfolio that is growing faster than inflation to ensure that you can retain your standard of living in retirement.
Understanding the basics will help you to get a better understanding of what your advisor is talking about when you sit down to devise your financial plan. An advisor will discuss these concepts and how they impact your retirement savings, so don’t be shy to ask questions.
- Maria Smit CFP® professional is an advisor at Brenthurst Pretoria [email protected]
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