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!

Types of investment growth

A few months ago my wife asked me to explain to her the difference between interest, dividends and capital appreciation. If we add in income then these are essentially the different ways in which money in an investment can grow. I'll admit that up until now I've probably been a little vague about the distinction between these different mechanisms of growth so I'll try to rectify that in this post. 

In the long run, all these forms of growth kind of end up doing the same thing - they all grow your money. And if we draw graphs of investments that experience these different mechanisms of growth then the graphs would look exponential:

These are the same graphs that are produced by the "compound interest" formula that we looked at in an earlier post. 

All types of growth can look a lot like a lot like compound interest and they behave a lot like compound interest as well. Money grows at a certain rate per year and in subsequent years you get growth on growth. Compound interest is just a specific type of compound growth.

So if everything kind of looks the same and does the same thing then why is it important to make the distinction between these different mechanisms of growth? Why don't we just call everything interest and be done with it? Two reasons:

1. The "rates of growth" typically associated with each mechanism of growth can be very different. So some mechanisms will act faster on your money than others.
2. The different growth mechanisms are taxed differently. You need to know how they are taxed so that (a) you can invest in a tax-efficient manner and (b) you know how and where to declare the proceeds of your different investment growth mechanisms (the return on your investment) in your annual tax return.

These growth mechanisms are what cause the Financial Independence Engine to run and they cause it to run in slightly different ways.

Without further delay let's develop a rather silly analogy that will serve to illustrate the distinction between the different mechanisms of growth.

Edgar is the owner of a bakery that specialises in baking with interesting varieties and sizes of eggs - quail (small), duck (medium) and ostrich (large!). 

Photos used in the above image (left to right) credited to:
Roberto Verzo, snowpea&bokchoi and Beck (all CC-BY 2.0).

When Edgar does a stock take to see if he has enough eggs to cater for a large retirement party he doesn't worry about how many of each type of egg he has - he is only concerned about the total amount of eggy goodness he has (the rich golden yolk in particular). Quail eggs are the smallest with less yolk per egg, next come duck eggs and lastly the ostrich eggs with lots of yolk per egg.

In our analogy, the amount of eggy goodness or the yolk represents the rand and cents value of our investment. The different types of egg represent a single "unit" of an investment - for example a "unit" in a unit trust, a single share in a company or a gift card.

Egg yolk is the currency in this eggsample :-)
Photo credit Emilian Robert Vicol (CC-BY 2.0)

Let's continue...

It turns out that Edgar has more than enough egg yolk for the retirement party that he needs to cater for. In fact, he has so much extra egg yolk he's able to lend it out (in the form of eggs) to some of his friends who are also in the exotic egg catering business. In return for lending out egg to his friends in need, they will return the amount of yolk that they borrowed plus they will give him some more (either in the form off egg yolk or in the form of eggs). Let's look at these different business dealings in turn.

Edgar earns interest from Alice
For every litre of egg yolk that Alice borrows from Edgar she promises to give him back the original amount of egg yolk plus 10% extra at the end of the year. On 1 January Alice borrows 20 litres of egg yolk. After a successful year in business Alice returns to Edgar on 31 December and gives Edgar 22 litres of egg yolk: 20 litres being the original amount borrowed and 2 litres (10% of 20 litres) being the interest. Edgar now has more egg yolk than he started the year with; his investment has grown.

Edgar receives dividends from Bob
Edgar thinks Bob's Egcellent Eggs, is a great company to invest in and he invests 100 duck eggs in Bob's company. When the company makes a profit, Bob likes to give all the profit to his shareholders - these company profits distributed to shareholders are called dividends. After a great year of business Bob pays Edgar a dividend of one litre of egg yolk. At this stage Edgar could take his egg yolk and make himself a decadent and fancy omelette. But seeing as he's not retired yet, Edgar does best to reinvest his dividends. One litre of egg yolk is roughly the amount of egg yolk in 10 duck eggs so Edgar gives Bob another 10 duck eggs bringing up the total of his investment to 110 duck eggs with a value of 11 litres of egg yolk. 

Edgar earns capital appreciation through Cathy
Edgar decides on a long term investment in Cathy's Egg Emporium. He lends her 10 duck egg in January 2000. Cathy is incredibly focused on growing her company. If the company makes any profits, she pours them straight back into the company instead of paying it to the shareholders. So although the shareholders don't get any benefit immediately, they own a share of something that is worth more and their investment has grown. In December 2024 Cathy gives Edgar 10 ostrich eggs. How many eggs did Edgar have in 2000? Ten. How many eggs does he have now? Ten. So Edgar has the same number of eggs, each egg is just worth a lot more (in terms of yolk). This is capital appreciation. With capital appreciation you own the same thing (such as a house) or the same number of things (such as shares in a company), but each thing you own is simply worth more.

Edgar earns (rental) income from Dave
Dave runs a fancy coffee shop frequented by tourists and he thinks having some ostrich eggs on display in the window would be just grand! 

Photo credit: Redmond (CC-BY 2.0)

He arranges with Edgar to rent 20 ostrich eggs, in return Dave will give Edgar 2 litres of egg yolk (from chicken eggs from the coffee shop kitchen) per year. Assuming that an ostrich egg holds 1 litre of egg yolk, Edgar has received a 10% return on investment (eggs with 20 litres of yolk rented out and returning 2 litres in rental income).

Cracking open the analogy

Interest and income
When your investment grows through interest you get more units, but each unit has the same value (each rand is worth one rand, but you have more of them). Interest gets paid to you regularly.

When your investment grows through income you also get more units and each unit has the same value. You also get paid regularly. So income can look a lot like interest. So what's the difference? Consider the example of Alice who paid interest on the borrowed egg yolk and Dave who rented the ostrich eggs from Edgar. The only difference is the form of the asset that was borrowed. Dave was borrowing something that was not egg yolk itself (ostrich eggs) but had a value in terms of egg yolk and he needed to pay rental to enjoy the privilege. Alice was borrowing a certain amount of yolk (which is equivalent to cash in this analogy) and she needed to pay interest for this privilege.

Dividends and capital appreciation
Bob and Cathy represent two extreme ends of the spectrum of how companies decide what to do with their profit. Many companies will pay some of the profits out as dividends to shareholders and retain some of the profits for furthering future growth. When Edgar earned dividends he earned it in the form of egg yolk (the cash currency in this analogy). He then had the option of keeping his dividends or reinvesting by buying more shares of Bob's company (measured in terms of duck eggs in this case). By reinvesting he increases the value of his investment because he has more shares, not because the shares he has are actually worth more. From Cathy, Edgar received no dividends and no intermediate payments. By retaining all the company's profits Cathy was making each share of Bob's more valuable. After 24 years Edgar's 10 eggs invested in Cathy's company were so valuable that he needed to receive ostrich eggs when we cashed in on his investment. In this example he had the same number of units of investment, but each one was worth more.

Remember that interest only barely keeps up with inflation (sometimes it doesn't even do that) so although it's useful it should not be your primary source of investment growth.

When you invest in companies through unit trusts, ETFs (Exchange Traded Funds) or actual shares you'll benefit from both dividend income as well as capital appreciation in the long term. Some companies pay out more dividends than others and there are unit trusts and ETFs that try to have a higher proportion of high dividend paying companies.

Rental income is useful (but see the tax implication below) and an easy way to have some exposure to it is through unit trusts or ETFs focussing on owning and renting property. You'll also get some capital appreciation through these unit trusts or ETFs as the values of the properties rise over time.

Tax implications

You can earn R23 800 worth of interest in a single tax year before you start paying tax on interest earned. You'll need to declare all interest earned from all your investments. You can get this amount by adding up all the amounts labelled "local interest" on the IT3(b) statements that you'll get from your financial management people and banks.

Dividends that you earn are taxed in the hands of the company before they are paid over to you. You'll need to declare all dividends earned in the "other non-taxable income" category on your tax return (and follow the same approach of adding up all the dividend amounts on your IT3(b) statements.

From year to year you'll probably not need to worry about tax on captial appreciation. This is because you'll only pay tax in the year that your investments are sold. This will (hopefully!) result in a large capital gain which follows the rules of Capital Gains Tax as described in the post on tax.

Investment income (such as rental income in the above example) is taxed in the exact same way as your regular income from your job. The full amount is included in your taxable income (no exemptions like interest income or the same benign treatment as capital gains tax)

A fifth way of growing your money!

The four mechanisms of growth that we've discussed so far are not the only ways to grow your investment. You can also manually put money in yourself! This is money that you have saved for the purposes of investment. It's the fuel required for the Financial Independence Engine before it starts running itself. 

In the short term, the amount that you are able to put in will far outstrip the investment returns from any of these types of growth. But eventually these growth mechanisms (the backbone behind Pillar Two) will start to earn more than you possibly can. The huge advantage of the investment growth mechanisms discussed in this post is that they are a type of passive income - meaning you don't have to work once they've started out earning you - this is the stage at which you've earned your financial independence.

The relationship between investing and borrowing

You might have noticed that depending on how you read the examples of Alice, Bob, Cathy and Dave they could sound a lot like credit and borrowing. Yikes! How did an example about an investment start to sound like an example about borrowing? Investing (or lending as in the example above) goes hand in hand with borrowing. When you invest in some investment product or company they are essentially borrowing money from you. From Edgar's perspective he's investing. From Alice's perspective, she's borrowing (as long as she's borrowing in order to expand her business, that's fine - as long as she doesn't start funding a decadent lifestyle on egg yolk credit!).

In a post that I hope to write soon we'll look at the different options of where to invest in South Africa. In the meantime I hope you've found this post useful!

Choosing a bank

When you think about saving money, what's the first thing you think of? Well, probably the bank, right? Most of us believe that keeping a pile of cash under the mattress is a bad plan, so... we have to make use of bank accounts. 

However, the sad truth is that putting money in the bank does not always result in that money working for you. Sometimes, especially in South Africa, you can actually LOSE money by keeping it in a poorly chosen bank account - don't forget that the vampire of inflation is always on the move, and if you add in stupendous bank charges and low interest rates... well, sometimes the mattress starts to seem like a pretty good option.

Not really. Mattresses don't allow you to make payments over the internet. And of course rather vulnerable to theft! But the truth is that in order for your cash to work as hard as possible, you need to pay a lot of attention to where you bank.

Squirrels do well to hoard nuts in secret locations.
You also need to keep your money in the right location!
Photo credit Tomi Tapio K (CC-BY 2.0)

I have always paid considerable attention to bank charges - long before financial independence became a goal. My attitude towards bank charges and interest has always been along the following lines:

Banks exist to pay me money, not the other way around.

Banks should be honoured to have access to my savings in order to loan to others at a high interest rate. At the very least I should break even and the total of all bank charges should be less than the interest that I earn on my savings in a bank account.

Your personal banking package

It is useful to think of your overall "personal banking package" which could consist of one or all of the following components:

1. transactional account - the account from which you are able to perform transactions (deposits, internet banking payments etc.)
2. savings account - a linked account which usually earns higher interest than the transactional account, but has limited transactional functionality
3. credit card - dangerous, but they have their uses as discussed in our post on debt
4. rewards programme - some banks reward you for how you bank with them, how often and how much you use your credit (or debit) card with them such as uCount (Standard Bank), eBucks (FNB), Greenbacks (Nedbank) and Absa Rewards.

The above package may all come from the same bank or it could be something that you construct from different banks and financial institutions (this is the option that we have taken). 

The ideal banking package

Purely from a monetary perspective, the best package is the one that costs the least (if interest and rewards earnings are less than your bank charges) or the one that earns the most (if interest and rewards earnings are greater than your bank charges). Ease of use, location of branches and other features such as sms alerts, mobile apps etc. should not be neglected, but make sure you think very carefully about what you actually need out of a banking package as opposed to the nice extras that a bank will try to sell you or hook you with.

The following is what I consider the ideal banking package for my family:

1. Internet banking! Being able to make payments online is a non-negotiable for us.
2. A single account from which to transact that also earns interest at a high rate.
3. A simple fee structure at the lowest possible cost.
4. A credit card for managing cash flow - the actual interest rate on the card is not important as we never plan on paying interest on it. What's important is that we have at least one month interest free and that any costs involved are less than the interest we earn on the money that stays in our bank account.
5. A rewards programme if and only if it earns more than it costs and if it falls in line with our usual spending habits (how much money we spend, what we spend it on and where we spend it: in other words, so we don't spend more by trying to save money).

Fee structures

Most bank accounts have a fixed monthly cost in addition to costs per transaction. Some bank accounts are "pay-as-you-transact" (with a low fixed monthly fee) and others come with "bundled transactions" (a higher fixed monthly fee, but with either a near-unlimited or fixed number of transactions included).

In order to determine which is best for you, it is important to determine what types of transaction and how many of those transactions you would typically perform every month. The main transaction types to consider are:

1. External debit orders (retirement annuity contributions, credit card repayments etc.)
2. Internet banking payments / EFTs (rent, monthly donations etc.)
3. Cash withdrawals at till points (smaller amounts).
4. Cash withdrawals at your bank's ATM (larger amounts).

Think about how many transactions you really use, and whether the bundled transactions are worth it. Although each transaction may be cheaper if you transact a lot, the fewer transactions you make, the less likely it is to be worth  your while. This is certainly what we found when we switched to a much cheaper pay-as-you-transact account. Although each transaction was theoretically more expensive, we still came out ahead. 

Interest earned on your bank account

Surprisingly, most transactional bank accounts don't actually pay you interest (or pay a very low interest rate) on any money you have in them. Instead, the bank offers you a linked savings account into which you need to transfer your money and then you can earn interest on that money. But you can't easily access those funds directly: they first have to be moved back into the transactional account. 

What this system has in its favour, is that your money earns interest in a place that is slightly harder to access - so if you don't have very good money discipline (yet!) then this could be a helpful feature. However, this feature is also the biggest downside of this system. You need to estimate very carefully how much you actually need in the transactional account so that you can maximise the amount that earns interest in the savings account and you're usually limited to how many times you can transfer from the savings account into the transactional account. What a schlep! 

What we need is something simple - a single account from which we can transact and earns a decent rate of interest.

Credit cards

As mentioned in a previous post, we don't have the luxury of choice in credit cards that they seem to have in the US. So instead of choosing the card that gives you the best rewards we're looking for the card that costs the least. Things to consider when choosing a credit card:

1. Credit cards usually have a fixed monthly fee or a fixed annual fee. (Choose one that is zero! Credit cards aren't actually worth paying for.)
2. Make sure you have access to either internet banking or emailed statements.
3. Make sure that you have at least one month (most in South Africa give 55 days) interest free.
4. Using your credit card for cash withdrawals or for purchasing petrol will cost from the very first day - rather use your debit card for these.
5. If you get your credit card from the same place you have your bank account these are sometimes bundled together. Make sure that the bundled cost is less than the cost of a stand-alone credit card from one institution and a bank account from another.
6. Credit cards are often an integral part of banking reward programmes. Again, you'll need to perform some calculations to see if paying the associated fixed monthly fee in order to have access to the rewards programme is actually worth it. (Spoiler: in most cases, it isn't!)

Rewards programmes

It's important to perform the detailed calculations for yourself to see if belonging to a rewards programme is worth it. I'll give you some of the major things to consider here, but you'll need to factor in your own spending patterns. 

The best approach to calculating if a reward programme is worth it looks something like this:

1. Work out your ideal banking package and spending patterns while ignoring the existence of any possible rewards programmes. 
2. Then see how much extra joining the bank and the reward programme will cost.
3. See how much you would need to alter your spending pattern to get certain benefits from the rewards programme:
• Do you need to spend more than you would without the existence of the rewards programme?
• Will you be limiting your freedom because you're required to change most or all of your banking habits just to get certain rewards or achieve a certain level of rewards?
• Do you need to do your shopping somewhere inconvenient or further away? If you need to drive further away than your closest shopping centre then this will add to the cost of joining the rewards programme.

It is really important to remember that rewards programmes are essentially marketing tools. This means that in most situations, the company is going to make more money out of your participation in the programme - otherwise they wouldn't offer it. It can be win-win, but the company is always going to come out ahead; after all it is their game. 

Also, by their very nature these programmes reward consumption: something which we are trying to cut down on. If you are being very frugal, they will have nothing to reward you on. So you need to be very sure that you can game the system before going for a programme like this.

So what is our personal package?

We do our banking with Capitec and we have a credit card from Virgin Money. We haven't bothered with any banking rewards programmes.

Without actually specifically advertising either of these institutions (if their packages change we will always be willing to move) I'm happy to go through our logic about how we came to the above combination:

1. Capitec charges low fees, the fee structure is simple.
2. Capitec offers very good interest on your bank balance - and they don't bother with a separate transactional and savings account.
3. Virgin Money costs us absolutely nothing.
4. The combination of the above means that our banking package earns us more than it costs us which is just how I like it.
5. We'd need to adapt our spending far too much for any of the banking reward programmes to make sense for us - although they certainly are better value than they were a few years ago.

Something to note about your bank account: regardless of who you bank with, you shouldn't get too excited about their interest rates as only the essential day-to-day cash should be kept in your transactional account. The rest of your cash that is set aside to be easily accessible in case of emergency should be in a money market fund - safer and it will achieve slightly higher growth. Plus, it is never a good idea to keep all your eggs in one basket.

I'll admit, constructing the "optimal personal banking package" can be quite a complicated and demanding task. The "best package" can also change from time to time as the banks compete with each other and change their offerings. Don't let the perfect be the enemy of the good - find a banking solution that works for you and gives you only what you actually need. If the offering with the next bank is only slightly better, the hassle of switching banks is probably not worth it. 

But if the differences become significant, don't be afraid of going through the motions of switching. Don't be suckered by special platinum cards or loyalty rewards: a bank is a business, and you are a customer. If they are not fulfilling your needs, you need to move.

Going through the above process of evaluating your banking solution can be time consuming, but the potential savings are worth it. You can bank on it.