Basic Investment Principles

All about the principals of Investments, timing and management of Financial Investments.

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Basic Investment Principles

Background

The average investor has much more information at his/her disposal today than 10 years ago. Unfortunately this is not always a good thing. We now live in the information age where all information that is available at any moment in time can be accessed from anywhere in the world by the push of a button. Unless you can interpret these volumes of information and reduce it to a solution you will suffer from an information overload. This available information and the varied opinions that the “specialists” (and journalists) formulate and argue passionately with out cease tend to hit you like wall of noise. Where should you start?

Structuring an investment portfolio

We usually find that the first two questions asked in the investment planning process are:

  • What will the markets and the Rand do next?
  • What is your appetite for risk?

The answer to these two questions presupposes that:

  • You have a crystal ball and can predict the movement of the markets, and
  • That concept of risk is understood and properly defined.

Exploring risk

Investment management is a multidimensional exercise. Most investment strategies fail because of a lack of proper understanding of the concept of risk and how it should be managed. The average investor usually has a basic need for decent returns at the lowest possible risk.

Just for a second let’s try to imagine an investment world where there was only one dimension: rate of return. Investment choices might look like this: Rate of rerturn

All returns are certain. Investors would, of course, decide that more is better. Everyone would want investment A. No one would consider investment B. Investment B would cease to exist as a choice for lack of takers. Everyone would get the same investment result, and no one could aspire to a higher rate of return.

Now let’s imagine a second dimension: risk. Investment choices might look like this. Ad another Dimension

Most people view cash as a risk free investment. The risk-free rate of return is the interest earned on cash. You cannot expect a greater return without adding some additional risk. Risk is the price that you pay for higher returns. All investments pose some form of risk and it is important to have an understanding of how these various risks impact on an investment portfolio. An appreciation of risk will make you a better investor. Risk is real, and it should be built right into the investment process.

Risk profiling

Completing a basic risk questionnaire is not a mature or an intelligent way to structure a portfolio or to manage money. The only insight that you can gain from this exercise is to establish what your perception is of your appetite for risk at a given point in time. Most investors equate risk to volatility: the risk of loosing money over the short term.

Because of this they design investment strategies based on their perceived appetite for “risk”. This is a flawed approach because your appetite for risk is usually closely linked to the recent performance of the market – and that is a moving target. This approach focus’s on the investor’s emotional experience. However, successful investor’s are those who can take a step back and make decisions not driven by emotive factors.

Market timing

Investors and advisors will over time always be tempted to take a view on what is going to happen next in the markets. Journalists will always argue, with the benefit of hindsight, that the “signs were there” and that everybody should have predicted that the market was about to turn. Investment management is not about prophecy, but about probability. The truth is that nobody knows or can consistently predict the movement of the markets. This also is a moving target.

Do investors trade on momentum?

The average investor has the uncanny ability to time his/her beatings perfectly.

Evidence of momentum investing can be demonstrated by looking at the following examples of investments historically:

  • Small caps:

Over the 3 years from July 1995 to July 1998, small cap unit trust funds returned an average of 66% p.a.

From March 1998 to December 1998, R 1.95 billion flowed into small cap funds

Over the same period the sector lost 18.42%.

  • Local equities:

Over the 4 months from April 1998 to August 1998, the All Share Index lost 40.22%.

From June 1998 to December 1999, R 3.8 billion flowed out of the general equity sector.

Over the period from August 1998 to December 1999, the All Share Index returned 73.52%

  • Cash relative to equity:

Over the 4 months from April 1998 to August 1998, cash outperformed equities by 44.66%.

From September 1998 to June 2000, R 28.4 billion flowed into Money Market and Fixed Interest-Income funds.

Over the same period, equities outperformed cash by 30%.

The following graph shows the inflow of money, as a result of equity markets performing well. This illustrates how people buy high and sell low. Unitrust Securities

Managing the fundamentals

You should focus your attention on the things that you can manage. The detail (market and currency movements) changes all the time and cannot be managed actively. There are however a couple of basic fundamentals that have not changed through the ages and should form the basis of your investment plan.

Markets go up and down in cycles over time and nobody knows when this will happen. Equity markets at times are usually over-bought or over-sold but over time tend to outperform all other traditional asset classes. The caveat is however “over time”. The following graph of the JSE illustrates this reality: Price History All Share

Focus on risk management

The structure of your portfolio and exposure to various asset classes should be defined by your cash flow needs. It is imperative to have an understanding of when you will need access to which portion of your capital. Your net cash flow has a direct impact on your risk management strategy:

  • Short term:

The portion of your capital that needs to be accessed over the short term will be affected by the volatility of the markets. Here you do not have time on your side. The short term volatility of markets is nothing new and has been the case for hundreds of years. In future this will still remain as the short term risk.

  • Long term:

The portion of your capital that only needs to be accessed over the longer term will be affected by a totally different risk: inflation. Over the long term the volatility of markets is not your risk. The question is always whether you can still buy as much with your money in future. Can you maintain your lifestyle? The ultimate goal is to be wealthier, not just to have more inflated Rand’s! The graph below illustrates the difference between nominal and real values: Nominal vs Real Value

  • Medium term:

Your short term risk is volatility and over time inflation. Over the medium, term your risk is to be exposed to asset classes that behave in the same way and tend to under perform at the same time. This is called your correlation risk.

Being invested to various regions within the equity markets do not bring diversification as these markets tend to be highly correlated to each other. Bonds on the other hand seem to be de-correlated to equity markets. When markets fall central banks drop interest rates to stimulate growth in the markets. In this environment bonds perform well. When markets are buoyant inflation tends to creep in and central banks raise interest rates to combat this. The rise in interest rates then puts the brakes on the markets.

The following graph illustrates the various risks: What are the risks

Managing the risks

The best way to manage these various risks would be to structure building blocks that are focussed on addressing the individual risks.

  • Short term – Income

The easiest way to manage volatility is to not be in the market. You should structure an income building block that will give you mainly exposure to the fixed interest environment.

  • Long termGrowth

This building block must be structured with the purpose to beat inflation over time. This can not be achieved by being invested in low volatility asset classes such as cash. The after tax return should outpace inflation. In this portfolio you will have to assume more risk in order to get the required return.

  • Medium termDefensive

Here the focus will be to select funds that will give you a return in excess of inflation, but that will not be affected by negative market movements. This building block should give you the time that is needed for the growth portfolio to work.

In all these three portfolios will complement each other and will manage the various risks effectively. On an annual basis these portfolios should be re balanced in line with your cash flow needs. See the graph below: How to manage these risks

When we measure risk at the portfolio level, we can see that the best way to construct a conservative portfolio is not to have all “safe” assets, but to have a conservative mix of attractive assets. A risky asset with a low correlation to other assets in the portfolio can actually reduce risk in the portfolio. It’s a question of trying to get as much return for the risk as possible. A diversified portfolio offers much higher returns per unit of risk than does a utility or “blue chip” portfolio. Long Term Investment best

Conclusion

Risk profiling and market timing are useless and dangerous. Risk is not something that should be avoided in money management, but rather something that has to be managed. There has to be a clear philosophy and strategy based on the fundamentals – the things that can be managed. You need to add to that discipline and patients.

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