What are bonds and what are equities?
A bond is a loan made by you to a government or company when it needs to raise additional capital to finance new business opportunities. Bonds issued by governments are called government bonds, sovereign bonds or gilts, while bonds issued by companies are called corporate or credit bonds.
Equities are shares in a company. When you buy equities, you are actually buying a share of the company itself. As a part owner, you share in the success or failure of that company and these fortunes are reflected in the share price on the stockmarket. So when the company does well and profits rise, the value of your shares go up, and when it doesn’t, the value of your shares will fall.
Bonds are generally affected by changes in interest rates rather than fluctuations in the stockmarkets. Their prices move less sharply than equities and they are thus often regarded as a safe-haven from stockmarket turbulence. Neither bonds nor equities are risk free so to reduce the risk of your portfolio you should consider balancing your investment portfolio with both bonds and equities in order to diversify these risks.
What is the difference between putting my money in a bank, a bond fund or investing in shares?
If you are looking to grow your capital at a higher rate and are accepting of relatively higher risks, your portfolio would lean towards equities. If, however, you are not willing to take risks with your income, you may want to increase the percentage of bonds you hold.
A rule of thumb to consider when calculating the percentage of bonds you should have in your portfolio is your age. If you are 58, for example, 58% of your portfolio should consist of bonds. Alternatively, if you are 63, then 63% of your portfolio should be in bonds, although individual circumstances vary and this is only a rough starting point.
In the long run, equities should outperform bonds but bonds typically provide higher levels of income than both equities or cash in the bank.
| Bank deposit | Bond Fund | Shares | |
| Income | Lower level of income | Higher level of income | Lower level of income which can fluctuate |
| Capital | No growth in capital but the return of capital is mostly assured | Some opportunity for growth but capital is secure | Higher possibility for growth but capital fluctuates and is not secure |
When is the best time for me to invest and how long should I invest?
Investing should be continuous and consistent because by investing often you smooth out the highs and lows of the market. When shares go down your regular contribution buys more than usual and when the share price subsequently rises, the value of your investment benefits accordingly.
| Prudential explains: The financial crisis of the past four years highlighted the fact that, over short periods of time, share markets can move up and down a great deal. In 2008, the price of the Johannesburg All Share Index, a basket of the shares of the largest 160 South African companies, fell 25%. In 2009, it proceeded to rise by some 28%. After allowing for the modest income from dividends, for someone who put a lump sum to work on December 31 2007, two years later the value of their investment would have got back to where it started. Hardly a stunning result. In contrast, if someone had put R1 000 in the market per month over that same period (a total of R24 000 over the two years), their investment would have been worth almost R28 000 on December 31 2009, demonstrating that, by investing regularly, much of the effect of market volatility is removed. |
Investing requires a long-term view and virtuous patience, which in essence means an investment needs at least five years for its earning potential to be realised. We all want more money but that is just part of the reason for investing.
The other part is how you want it delivered.
This can be done in two ways: a “regular income” (which gives you regular payments) or “growth” (a big lump sum received at the end of your investment period).
Smart individuals choose to invest with a long-term view but before you invest you must consider what you want from your money to determine the time you need to invest for.
I’ve decided I need to invest my money but how will my portfolio or fund be managed?
The degree of risk is related to the type of fund you choose. How the fund is managed also impacts the risk involved. There are two ways your fund can be managed.
Active management
A highly experienced and specialised fund manager works on your fund constantly to maximise the profits. They work closely with a research team and use their insights and knowledge to decide on the shares that are most likely to give a return on your investment.
Passive management Index Funds.
They are called “Tracker Funds” and are not actively run by a fund manager. Their returns follow the performance of a particular index, for example, the FTSE/JSE All Share index (which measures over 160 companies on our stock exchange). These are useful if you want to invest in a certain type of company or sector as some indices track particular sorts of companies.
How do you know which investment approach is best for you?
Selecting a top quality active fund manager should, in the long run, provide a better outcome than a passive strategy. However, this is not always easy. In addition, investors must then guard against the natural instinct of switching. Prudential’s track record in South Africa does show that, provided the manager has a disciplined and robust investment process, active management will usually out-perform passive management over time.
I can see how you can help my money grow but how do you help reduce the investment risk at the same time?
Here are four simple ways that you can use to make investing less risky.
- Invest in an equity fund rather than single shares. In this way, your money is a pooled investment alongside other investors and managed by a fund manager. He ensures your money is spread across a number of different companies, sectors and even regions to avoid all your eggs being in one basket.
- Invest for the long term. Ideally, you should plan to invest for at least five or preferably 10 years. Markets tend to fluctuate over the short term but over the longer term the peaks and troughs tend to be smoothed out.
- Invest regularly. Investing at regular intervals can be a good idea as it is likely to mean the average price you pay for shares can be lower than if you make one lump-sum investment. Over time, regular investments can help to smooth out the peaks and troughs in the market.
- Diversify your investments among different asset classes. Build a portfolio that includes higher risk investments like equities and lower risk ones like bonds or even cash. The particular balance of your portfolio, or asset allocation, will depend on your expected return, your attitude to risk, your age and your longer term financial goals. Asset allocation is one of the most important factors in investment success.
What is asset allocation?
Asset allocation is the process of deciding how much money to invest in each asset class. To make the most of your asset allocation decisions, you first need an understanding of asset classes and the importance of strategic asset allocation.
There are four broad classes of assets available to you when building an investment portfolio: shares or equities; bonds; money market and cash and equivalents; and property.
It is important to have different asset classes in your investment portfolio to take advantage of the different strengths and characteristics of each class.
The characteristics of each asset class vary in terms of their differing levels of income and the circumstances in which they may grow or fall in value.
Some are easier to turn into cash (if you suddenly have unexpected expenses, for example) and they all have different levels of risk.
| Prudential explains: When you buy a share, you are participating in the ability of that company to grow in the future (or when the investment is in a fund, you want the profits of that basket of shares in the fund to grow). There are many factors that influence how fast a company can grow, including the degree of competition in its market segment, the strength of the brand, the soundness of company management and so on. Companies differ in these regards. But one factor that affects all companies is how quickly the economy itself is growing. For example, if consumers are spending more this is likely to help companies increase their profits as they sell more goods and services. Hence, over time, stronger economic growth should help share prices to rise. However, when economic growth is more robust, interest rates are likely to be rising. When interest rates rise, the prices of bonds fall, so, in general, economic expansion will be worse for bonds. Blending equities and bonds into a portfolio can therefore help to reduce overall volatility of your capital, as often when shares are doing well (the economy is growing strongly), bonds will be performing less strongly and, of course, the reverse applies when growth becomes more sluggish. Since economic growth ebbs and flows over time, in what many see as a very unpredictable fashion, deciding on a broad allocation between these two assets that you stick to over time can help smooth your returns.Combining different asset classes in different proportions will help you achieve your investment objectives and take less risk to do so. |
Asset allocation is basically the long-term diversification of your portfolio between asset classes such as 60% to shares, 30% to fixed interest and 10% to cash. Ideally, this allocation should match your longer-term return and risk requirements. As we noted earlier, for most investors, decreasing riskier assets like property and shares in favour of bonds and some cash is a prudent course of action as you age.
If you don’t wish to make asset-allocation decisions yourself, then you should ask your financial adviser to assist you.
At Prudential, we offer a range of solution funds where we do the asset allocation on your behalf.
