No one expected the interest rate hike last month, and certainly not the rand and market fallout that followed.
If you had been reading the press, there had been concerns around the price of the stock market and the fact that the rand was looking vulnerable as the current account deficit continued to balloon.
Investment experts called for investors to diversify offshore and to show caution when investing locally. However, when exactly the blow would occur and what would set it off, no one really knew. What we can learn from this is that diversification is our greatest protection.
Take, for example, a portfolio that had, over the past year, the following asset allocation: 30% local equities, 30% foreign equities, 10% property, 10% preference shares, 10% bonds and 10% cash.
For the year up to April, the 30% in local equities and 10% in property would have been flying, contributing nicely to the bottom line. In particular, the industrial and financial shares in the local portfolio were really performing, making some of the rand hedge shares look like a drag on performance.
Just as you start calculating how much more profit you would have made if you had put all your money in property and local equities geared to the lower interest rate environment, there is an unexpected -emerging market correction followed by an even more unexpected rate hike.
But you are still -smiling because now your foreign equities really start to perform as the rand plummets, and your income from your cash and preference share allocation has suddenly risen.
The pull-back in the market has eroded some of the gains made last year, but overall, you are still up on your local equities (your rand hedge stocks have held up well and you are now grateful you have them).
But now you are also getting a kicker from the other areas of your portfolio.
This is the beauty of diversification. It is so simple — it does not require you to be an investment boffin, it assumes that no one can guess the market perfectly and makes sure that you always have something to smile about when you read the papers each morning.
Paul Hansen, director at asset -management house Stanlib, notes that it took some flak during recent presentations to investment -advisers, who complained that Stanlib’s -highest allocation to listed property in its five risk–profiled funds was just 15%, and in one instance was down to 10%.
At the time, listed property was enjoying four years of good income earnings and solid capital appreciation. A month later, values were down 22%.
“We were asked why we were so cautious. It was not rocket science. We simply applied our basic -diversification philosophy and showed a little caution after a good run,” says Hansen.
“If market history is any guide, take a long-term view and a diversified approach, and the gain will eventually kill the pain. Short-term market volatility becomes a mere blip in the long term.”
Stanlib’s asset allocation process is a good example of how to manage your portfolio.
Taking money off the table after good gains and staying well diversified is always prudent. As an individual, the best way to accomplish this is to work out your long-term strategic asset allocation. This is the one that applies to your risk profile.
So, for example, if your investment horizon is 20 years, you can take a bigger stake in equities than someone with an investment horizon of five years.
Within the equity selection, it makes sense to have offshore exposure as South Africa only makes up 1% of the world’s gross domestic product and suffers occasionally from emerging market contagion.
Your local equities should be well diversified across the various sectors such as industrials, retail, commodities and banks.
Once you are comfortable with your asset allocation, review it regularly. Sectors that are performing extremely well will start to increase their overall weighting.
Once your portfolio starts looking too heavily weighted in one area, for example your 30% allocation to local equities is now sitting at 45%, sell off some of the profit to balance the portfolio.
You are locking in profit and selling high rather than low.
You may not perfectly time the peaks and troughs, but you should have a smoother ride.
Tools to narrow down your unit trust choice
Behavioural economics shows that when faced with too much choice, people simply can’t choose. So this is a real problem when it comes to selecting a unit trust fund. With more than 870 funds to choose from, consisting of 550 local and 320 foreign-registered funds, collective investments are a quagmire.
However, to assist investors, the collective investments industry has designed a simple tool that groups like funds with like. The Association of Collective Investments’s (ACI) fund classification works on a two-tier system.
Local or global?
The first tier determines regional allocation. Your first decision is how diversified your portfolio should be. The funds are broken into four areas, depending on where in the world they invest:
Domestic category funds must have at least 70% invested in South Africa;
Worldwide category funds invest a minimum of 30% locally and 30% offshore;
Foreign category funds must have at least 85% offshore; and
Regional funds must have at least 85% in a single country or region.
Stick to the broader categories
In the second tier of the fund classification system, each of the areas is then further categorised by what they invest in, namely equity funds, asset allocation funds and fixed interest funds. The broad categories are then sub-divided again into detailed and specialist sub-categories, but the ACI recommends that these funds be left to experts and professional investment managers.
Most investors, unless they follow the markets and economy very closely, should probably only be looking at a few categories such as broad general equity, and any of the asset allocation or fixed interest funds. Based on an analysis of their circumstances, investors will then be able to identify sectors in which to invest and how much money to place in each of them.
This means that instead of relying on a hot tip from a golf partner, investors can objectively and sensibly choose the most suitable categories to make up their portfolios.
Understand your risk and requirements: capital, income or balanced?
The trick is to start off with your own personal circumstances and goals. Once you have identified these, you are in a position to see how much or little risk you can afford to take. Risk is hard to quantify as it can mean different things to different people. For example, it is very risky not to have a large equity content in your portfolio if you are young as you need to ensure that your investment keeps pace with inflation. Likewise, if you are nearing retirement, having too much equity is risky. For those with tax issues, equity investments are still probably a better option as they can reduce tax liability.
Only once you have done this exercise, and worked out which categories to invest in, should you be looking at individual funds.
Fund selection: manager choice
At this stage, personal choice comes in. You may prefer or trust a certain company, or perhaps you are influenced by the long-term track record and performance of a certain fund. If you can, find out a bit about the person or team managing the fund and make sure they have been running it for a while. A financial adviser or broker can help.
If you have used the ACI’s fund classification properly, your job of selecting funds should be easier and more scientific. The objective of making your investment decisions less risky will have been met — and your portfolio is more likely to perform to the maximum.