Before you take the plunge and start building an investment portfolio, something to take into account is portfolio diversification. Of course, your wealth manager will be the one who is clued up on the assets in your portfolio but it doesn’t hurt to know what are the components of your portfolio and have an idea of how much risk and expected return you stand to gain from mixing different assets across different classes.
When you start building an investment portfolio, you’ve got two options. You can diversify your portfolio from a top-down strategy by starting with asset allocation and then moving on to security selection or you can start with a bottom-up strategy by selecting specific securities first and then moving on to asset allocation. For those who are not familiar with the terms “asset allocation” and “security selection”, here are some guiding explanations:
Asset allocation: This is the allocation of your investment portfolio across a broad class of assets such as stocks(shares), bonds, commodities or derivatives and options. As you can see this strategy is efficient because while you diversify your portfolio, you can strategically choose to spread the risk of your portfolio across the equity market(stocks), debt securities(bonds) and/or option contracts(derivatives). Generally, the debt securities market bears less of a risk than equity markets. So depending on your risk appetite, you can split 70% of your portfolio into debt securities such as government bonds and bills (which guarantee payment of your coupons and face value). Then, if you want to cash in on stock market movements, 30% of your portfolio can be composed of stocks of various companies. When looking at diversifying your portfolio, looking at how to allocate your funds is imperative.
Security selection: This strategy looks at choosing specific securities to hold in each asset class. So instead of looking at the 3 financial asset classes first (debt securities, equity markets and derivatives), this investor takes a bottom-up approach and looks at particular securities that they are interested in. When taking this approach to diversifying your portfolio, it is essential to be aware of the potential risks and returns of the securities selected. You might just look at the returns of only shares on the S & P 500 that look like they have high rewards and invest 100% of your portfolio in those securities and then, 3 months down the line, a corporate scandal knocks the stock price right down. Had you integrated a few government bonds that are essentially risk-free, you could expect to at least get a consistent coupon payment from your portfolio. In essence, I would definitely say, use this investment strategy with caution.
Whatever method you choose to diversify your portfolio, the advantages of doing so cannot be reiterated further. The effects of the unique risk of each underlying asset in your investment portfolio is diversified away to reduce the overall risk of your portfolio. Though for every class of assets, systemic or non-diversifiable risks will still exist due to uncontrollable macroeconomic events, investing across a broad class of assets will most certainly aid in mitigating non-systemic risk. Here’s a hypothetical example of the expected return you could expect to get from investing in the following asset classes:
Expected return: 5% (completely risk-free)
Portion of portfolio: 40%
Shares in JSE Listed company
Expected return: 15%
Portion of portfolio: 60%
Expected return= (Portion in Gov Bond x r) + (Portion in Stock x r)
= (40% x 5%) + (60% x 15%)
This rudimentary example is just a brief look at how investing in different classes of assets can allow you to still earn a good return from the complete portfolio while minimizing risk. Of course, the calculations that your wealth manager will do are far more complex than this, but for a basic understanding, this is a good place to start.
In your extra time, head over to google and look at the returns you can get from government bonds, corporate bonds and shares in the JSE. If you don’t have thousands of rands to put into an investment portfolio and can’t risk investing all of your money in shares, then allocate some of your extra cash in the debt securities market. Use the basic calculation above to see how much return you can expect to receive from mixing bonds and stocks. It’s important for us to take concepts of investing from the financial offices and boardrooms to ordinary persons so that the field doesn’t look as intimidating as it sounds. I’ll end the week off with a quote that’ll cement the idea of asset allocation in your minds for the weekend. Tony Robbins is quoted to have said: “the difference between a failure and a success is not which stock you buy or real estate you buy. It’s asset allocation”
Author: Sthandiwe Msomi