Investment portfolios explained

Cape Town - Through the first two articles in our 2014 Savings Month series, you started a savings habit and chose the appropriate vehicle with which to save. We will now address the construction of your portfolio within a savings vehicle.
 
In the case of most savings and investment products (with the noticeable exception of bank savings products) you will have to choose the investment fund(s) that make up your portfolio from what can seem like an endless universe of options.

Before we discuss fund choice itself (which will follow in Part Two of this article), it’s important to understand some basics regarding the asset classes commonly available to you. Investment funds are made up of either a single asset class, or a mixture of more than one asset class.

The assets contained in each of the four main asset classes can be local or offshore.

1. Equity

Sometimes also referred to as shares or stocks, equity is an asset class which represents listed shares in listed companies (shares available on a stock exchange such as the JSE).  

The investment return on equity is made up of two components: share price movements (these can be negative and positive) and dividends paid to investors (reliant on company profitability).

2. Bonds

These are debt instruments in which you, the investor, lend money to an entity that borrows the money for a predetermined length of time at a predetermined interest rate.  The borrowing entity can include governments, municipalities, and corporates (including parastatals).  

The investment return on bonds typically depends on the riskiness of the bond. Credit ratings are typically used as a reliable measure of this risk, and the worse the borrowing entity’s credit rating, the higher the interest rate on the bonds from that entity will be.

3. Property

Property, or real estate, is fairly self-explanatory in that this asset class is made up of physical properties, commonly commercial.  Property returns are made up of rental income received and any increase or decrease in the value of the property itself.  One of the easiest ways to access this asset class is by purchasing property stocks from an exchange such as the JSE.

4. Cash

Often referred to as the money market, cash has high liquidity and very short maturities (less than one year).  As such, cash is typically seen as a safe place to put money.  Cash does not only refer to notes and coins but also includes a range of other market instruments.  These money market instruments can be issued by governments, corporates (including parastatals) and banks.  

Offshore investments

These four broad asset classes are available both locally and internationally (offshore).  While the characteristics of each class remain the same regardless of the territory involved, purchasing assets internationally means that your eventual investment returns may also be impacted by any change in exchange rates.

Risk and reward

Risk is something that is inextricably linked to investment strategy. Many people consider it something to be avoided, but since risk and return are so closely related, the simple fact is that to see a good return on your investment, you must take on some risk. It is best not to avoid risk completely, but rather to endeavour to understand it.

Investment risk is essentially equivalent to investment return volatility (the amount of possible deviation from the expected return).  In addition, it is generally true that the higher the risk of the investment, the higher the expected possible return.

In general, from the least to most risky, the four asset classes may be listed in the following order: cash, bonds, property and equity.  And, as mentioned above, we would expect the asset class with the highest investment return to be equity and that with the lowest to be cash.

Diversification

While it is true that different asset classes have d  investments within an asset class and/or also holding multiple asset classes.

The theory is that within an asset class, and between asset classes, different investments will react differently to the world around them, which is why diversification will reduce the overall risk of a given portfolio.

In other words, when some investments are going up, others are going down and holding a diversified portfolio of them lowers your overall risk.  Retail investment funds are generally structured with some level of diversity incorporated.

The saying, “don’t put all your eggs in one basket”, is actually a diversification reference, and holds very true.

- This guest post was submitted by FutureGuide, which provides free financial tools and information to help people make the most of their money.

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