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!

Pillar 2: The Financial Independence Engine

Pillar 2: The Financial Independence Engine

(aka sensible investments)

Recall that the second pillar upon which a financially independent life is based is choosing sensible investments which will grow faster than inflation. You need to choose investments that give the biggest possible rate of growth (i in the compound interest formula). In this post I hope to give some background to the options available to you.

Our Financial Independence Engine. Next stop, "Freedom!" Choo Tjoe!
Photo credit State Library of Queensland (no known copyright restrictions)

Saving vs Investing

Firstly, it's important to make a distinction between saving and investing.

Saving is a verb - it's what we do as we build up Pillar 1. We live a frugal lifestyle and the money that we're no longer spending on things we don't need we save. But once the money has been saved it has to be put somewhere.

Savings is a noun - it refers to our saved up cash.

Cash in a treasure chest may look pretty, but it's the Engine we are looking for.
Photo credit Tom Garnett (CC-BY 2.0)

 Now cash doesn't necessarily mean actual coins and notes. It can refer to something like a bank account, a fixed deposit or a money market fund: where your money is somewhere invested in actual coins and notes, and (some) of the interest on that is passed on to you. This is what we call a cash investment.  The thing about all of these cash investments is that they won't be working hard in the way that you need them to in order to build up Pillar 2. Even when you're earning interest on your cash (alarmingly NOT always the case in South African banks), this interest is usually in line with or lower than inflation.

Cash is not King
Cash is a Lazy Prince who is vulnerable to the Vampire of Inflation

Inflation is a Scary Vampire, but there is a way out!
Photo credit Enokson (CC-BY 2.0)

At some point I'll do a post all about inflation. For the moment, all you need to appreciate is that inflation is the rising price of goods and services as time progresses. Inflation is the reason that prices go up and why salaries need to have "cost of living" increases. Inflation has hovered around 6% in South Africa for the past few years and at the moment it's about 4,5% - so let's just simplify things and say we're dealing with an inflation rate of 5% (to see historic inflation rates click here). Now not all goods and services rise with inflation - some rise faster and some rise slower. But it's a good way to estimate the price you can expect to pay for something from one year to the next - something that costs R100 today will probably cost about R105 next year.

The problem, of course, is that although your cash is growing (hopefully) it isn't necessarily growing fast enough to counteract the effects of inflation. If you earn R3 in interest but the price of your groceries went up by R5, you've actually lost R2; even though you might have thought that your savings was growing!

If you are getting 3% in interest (since we're hoping to be earning on significantly more than R100), that isn't good enough - over the course of a year your savings will still get effectively smaller by 2%. Do this every year for 10 years? You've lost a lot of money. It's still more actual rands than you started with, but it can't even buy the same amount as you could at the beginning. You are further from financial freedom than ever.

If you don't want to lose out to inflation then you're left with a few options:

1. Spend your money now before the Vampire of Inflation sucks its value dry.
2. Invest your money in something that grows at the same rate of inflation.
3. Invest your money in something that grows faster than inflation. 

The first option seems attractive - spend now before prices go up next week. Logical, right? But with this approach all we're doing is spending, not saving. We'll never have our money working for us and growing with compound interest because we'll never have any money. So let's scrap this option immediately. It goes against Pillar 1 because it will leave us with no fuel for our financial independence engine (Pillar 2).

And who would choose the second option if they could choose the third option? So let's see how to achieve growth faster than inflation.

We need to save money and then once we've saved it we need to put it into a suitable investment. So far we've determined that this suitable investment is not cash under the mattress, a bank account, a fixed deposit or money market. So what's left?

The Stock Market

All evidence spells out "Stock Market" as our Engine of choice
Photo credit Simon Cunningham (CC-BY 2.0)

It's by investing in companies listed on the stock market that we'll get the inflation-beating returns we're looking for. But wait, aren't stocks "risky"? The short answer is No. The longer answer needs us to define what we mean by "risk". In the world of investing, risk is related to the probability that your investment will lose value. Okay, we probably agree on that definition. But how can I say that the stock market is not risky if a company that you're invested in can go bust and lose it's entire value?

Let's be clear at this point. It is entirely possible to lose money in the stock market if you invest in any of the following ways:

1. Investing for the short term. Investing now and expecting to cash in on your investment within a very short time period. At any particular moment your investment might experience a temporary (but possibly very large) dip in value despite the fact that it is growing overall. You don't want to be forced to withdraw it during the dip.
2. Investing in a small number of companies and tying the fate of your investment to those few companies. Those companies might die a horrible death, in which case your investment has gone down the tubes. Don't invest in a company based on "a hot tip" from a friend or because the media is going crazy about it.
3. Trying to time the market by "buying low and selling high". This is a nice idea in principle, but it's impossible to consistently get this timing right. Regular people are not soothsayers or stock market geniuses.

So how do we invest in the stock market and reduce the above risk?

1. Invest for the long term - minimum 10 years.
2. Invest in a large number of companies - this is called diversification. If one company goes bust you still have money in all the other companies working for you.
3. Don't try to time the market. Invest regularly and consistently. It's not about timing the market, it's about time in the market.

At this point I think it's really important that you get a decent level of understanding of the stock market before you start investing. One of the Overseas Masters, jlcollinsnh, has done a wonderfully readable explanation of investing in the stock market. He writes from the perspective of the US stock market, but most of what he says can be applied to the South African stock market as well.

We're nearly at the point where we can start looking at specific places to invest your money in South Africa. But it really is important for you to feel comfortable and confident when it comes to investing the money that you have saved through Pillar 1 - this is why all this background has had to come before the specifics.

Until next time!

Pillar 1: Fuelling the Financial Independence Engine

Pillar 1: Fuelling the Financial Independence Engine

(aka Living a Frugal Lifestyle)

Photo credit trophygeek (CC-BY 2.0)

The more you can reduce your expenses, the more you have available to save and put into investments. Eventually these investments will be out-earning you and will be generating enough growth on their own to fund your lifestyle. 

Reducing expenses is more important than increasing income because it does two important things:

1. It means you can save more.
2. It means the target you need to reach is smaller so you'll get there sooner.

The first point is (hopefully) obvious:

income - expenses = money to invest!

But by itself it does not explain why reducing your expenses is more important than increasing income when trying to increase the amount of money you have to invest. To explain that we need to look at the second point. Remember that your sizeable investment will be growing at a certain rate above inflation. If the amount by which your investment grows is greater than the amount required to live then you can consider yourself financially independent!

  growth on investment > living expenses

                                            ⇒

financial independence!

If you live a frugal lifestyle your living expenses will be lower. If your living expenses are lower the the growth you require on your investment will be lower. Which means you need a smaller total investment to produce that growth.

Think Creatively to Live a Big Frugal Lifestyle

Some people are naturally frugal. But frugality is definitely something that can be learned. It eventually becomes fun and natural. At first it requires you to look at all of your expenses and re-evaluate them. Think outside the box. Don't assume that every expense is a given and that there is no way around it. Yes, some of them might be (if possibly only temporary), but you should at least try to think of creative solutions around them.

Spend some time drawing up a list of all the things you spend money on and try to find ways to find cheaper alternatives. Some expenses could be deleted from your budget permanently! In future posts we'll look at some specific examples of how we've reduced our spending.

Yours frugally,
Mr Cent(ri)frugal Force