Investing Basics I: Asset Allocation

At this stage we've established the importance of saving money in order to invest it. The Financial Independence Engine is most potent when powered by the stock market, but there are many ways to access the stock market so we'll explore some of these as we go along. Non-stock investments should not be overlooked - they add value at any stage of your financial independence journey and the role they play will change as your needs change.

This mini-series will be about where your money is (or will be!):

1. what form it's in (cash, bonds or stocks), and in what proportions
2. which companies and parts of the economy you've invested in
3. what type of financial product you invest in (fixed deposit, money market, retirement annuity, unit trust, ETF, tax free savings account etc.)
4. which financial institution you use as a platform

Let's start by understanding the different forms in which you are able to invest, why you would choose each form, and how you should decide on the approximate proportions of each.

Different forms of investments are called different asset classes
Photo credit: GotCredit at www.gotcredit.com (CC-BY 2.0)

Asset allocation
There are three main asset classes: cash, bonds and stocks/equities. In the investing world you might come across the idea of asset allocation. This is simply the ratio in which your assets are spread across these asset classes.

Cash
Essentially anything that earns interest counts as cash. Money placed in a savings account, fixed deposit, money market fund or similar are all examples of cash. In a previous post we established that cash is not the investment we are looking for because anything invested in cash typically only just about keeps up with inflation (sometimes not even). 

What cash investments offer that the other asset classes do not offer is accessibility. If you need money in an emergency or for day to day expenses the last thing you want to do is to be forced to sell off some of your longer term investments at a bad time - for example when the markets have taken a large (but temporary) dip. 

We have about 4,5% of our investments in cash form (Capitec bank accounts and Allan Gray Money Market Unit Trusts) and the rest is in as aggressive a form as we can make it. The cash component of our investment represents more than six months worth of expenses which is available in case of emergency and for cash flow. Building a buffer like this is important so that you never need go into debt. The cash component of our investments enables us to be more aggressive with the rest of our investments.

Bonds
When you lend money to an institution (or even the country itself) for a fixed period of time for either a fixed or variable interest rate you have yourself a bond. It's the exact opposite of the bond you might have on a house. Governments and companies make use of bonds to raise funds for pretty much anything - but since they're getting money they don't actually have yet they need to pay you interest for the privilege of having access to your money. 

Bonds are typically considered more risky than cash, but less risky than stocks. We haven't invested in bonds directly, but we definitely have exposure to bonds through the various unit trusts we've invested in.

The stock market... scary, or not really?
Photo credit: Andreas Poike (CC-BY 2.0)

Stocks / Equities
When you buy stocks or equities, you are essentially buying a small part of a business or group of businesses. You then share in the profits or losses of that business, either in the form of dividends or growth. Your shares in the company grow as the business grows.

The stock market is where you will make returns well above inflation if you're investing for the long term. However, in the short term, it is very possible for your stocks to decrease in value, which makes this seem like the most "risky" form of investment. Actually, the risk isn't as bad as it sounds: the risk isn't really that you will lose all your money (short of a catastrophe) but that at the moment you want to sell your shares they won't be at their most valuable. If you are able to wait for the correct moment to sell (either because you have time on your side because of youth, or because you have a good cash buffer) then this risk is minimised.

The real risk is losing out to inflation in the long term. Not the stock market. But it can definitely feel like it at times!
Photo credit epSos.de (CC-BY 2.0)

If you're investing over a long time horizon (30 years and more) then the risk of losing in the stock market is virtually zero. The real risk is not being in the stock market and losing the race against inflation. The longer you are invested for, the lower your risk.

Instead of working with the traditional asset allocation of "cash:bonds:stocks" we think of our asset allocation as as "things that roughly keep up with inflation : medium growth investments : high growth investments". The medium growth investments are more balanced, are typically Regulation 28 compliant (retirement annuity regulation that allows maximum 75% exposure to equities within the retirement annuity) and we're aiming to get about 5% above inflation on these. The high growth investments are pure equities and we're aiming for about 7% above inflation in the long term on these investments. 

We're very young so we've maximised our exposure to the stock market through unit trusts and more recently passive exchange traded funds (ETFs). These are simply mechanisms by which you can diversify (invest in lots of different businesses so that the risk of your chosen business failing is minimized) and reduce investment costs - more of that in the next Investment Basics post!