Investing. It’s something you have started doing. But, is it enough? Do you know enough to reach your goals?
First you need the answer to this question –why invest? You need to ask yourself - are you still in line with your investment goals?
Meeting financial goals
But there’s a bit more to it than that. Most of New York Times best-selling author Carl Richards’s book, The One-Page Financial Plan, centres on this single question: why invest? (Richards is most famous for his simple sketches that make complex financial concepts easy to understand.)
One of those sketches explains the investment process with four simple blocks:
- Financial goals
- Plan to reach goals
- Investments that fit the plan
That’s really why you want to invest – to reach some sort of financial goal.
Of course, you could stash away money under a mattress or in a bank account, but because of inflation, your money will effectively be worth less every year. Let’s assume you have R1 000 to invest in a savings account and inflation (the increase in the general level of prices for goods and services) was 6%. To buy the same goods and services you could buy with R1 000 last year, your money must grow by 6%. In other words, you need R1 060 to buy the same goods and services. However, you only earn 4.5% interest (or R45) in the savings account, which gives you a total of R1045. This means you aren’t able to buy the same amount of goods and services because goods and services have increased by 6%.
In other words, if you keep your money in a savings account you’ll be going backwards in no time – and you’ll be further away from reaching your financial goals.
Very plainly, investing is putting your money to work with the expectation of earning additional income or profit. In other words, making money from money.
The main investment most people make (whether they know they are investing or not) is saving for retirement. Regular contributions to pension and retirement funds will be put to work on your behalf, with the expectation of earning more money to provide financial stability when you reach retirement.
Tax-free savings accounts, which have been available since April, allow you to save up to R30 000 a year without the capital or returns being taxed. There are accounts offering exposure to a number of different asset classes.
Investing works over the long term because of one remarkable power: compounding. This is defined by Investopedia as “the process of generating earnings on an asset's reinvested earnings”. Over time, you earn money on previously reinvested money (we will explain this in more detail next month).
Where to invest
The most common places to invest are in equities (also known as shares or stocks), bonds (fixed-income), property and cash. These are the different asset classes and each can be accessed in a number of ways:
- Investing in property, for example, could be through a physical property or by buying exposure to property on equity markets (here you would buy shares in a listed property company, for example, real estate investment trusts, also called REITs).
- Cash is easy – a fixed-term bank deposit will earn you interest, so will money market funds.
- Bonds are debt instruments where you, through your purchase, are effectively lending money to a company or government in return for a fixed amount of interest over time. Plus, you are eventually paid back the money you lent out at the instrument’s maturity.
- Many investors invest in equities. Shares or stocks trade on equity markets, like the Johannesburg Stock Exchange, London Stock Exchange or New York Stock Exchange. Shares are exactly what they say: a share of the business. So, companies like MTN or Vodacom or Woolworths or, indeed, Discovery, would list on an equity market and issue shares in their businesses to raise capital.
Over time, these businesses will hopefully grow and thereby grow their revenue and profit, meaning that your share in that company would be worth more.
Investing in equities
Most individuals access equity investments through unit trusts (or collective investment schemes), exchange-traded funds or index funds. These funds typically offer some level of diversification: they hold a portfolio of companies (or asset classes) on your behalf.
These investments are either passively or actively managed. Passive investments would automatically track the companies in an index (for example, the JSE Top 40), while active investments involve asset managers making decisions about where to invest and where not to invest (with the aim of generating superior returns to the market).
Direct investments, where you’d want shares in a single company, are possible through stock brokers, and most offer do-it-yourself online platforms to buy and sell shares.
Risk and reward
Stocks are volatile. Their prices fluctuate daily, sometimes by a relatively extreme amount. But, along with this, stocks offer high potential returns. Shares in Woolworths, for example, have increased from R10 during the depths of the global financial crisis in 2008 to a few cents shy of R100 in 2015 – that’s a 1 000% return.
With this potential for large profits comes higher risk. As US investor and writer Howard Marks explains, with higher risks the expected return increases, the range of possible outcomes becomes higher and the “less-good” outcomes become worse (Source: Business Insider).
Each asset class performs differently in any potential market environment. Equities are generally regarded the highest risk, followed by property, bonds (medium risk) and cash (low risk). A critical part of investing is managing your risk.
In different circumstances and at different life stages, you’re able to afford different amounts of risk. Once in retirement, for example, could you afford having all your savings in equity markets, given the inherent risk? Remember, the value of the JSE practically halved during the 2008 financial crisis. Could you risk losing half your savings at the age of 70?
The best way to manage risk is through diversification. This means investing in different asset classes, as well as different shares or sectors or investments within each asset class.
It’s important to note that all investments carry fees and these vary, sometimes depending on their complexity. For some, you’ll be charged a small administration fee, while at the other end of the scale, you may end up paying performance fees to a professional fund manager, depending on returns achieved.
For more information on investing, speak to your financial adviser.
This article is part of an investment series by Discovery Invest.