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Financial investment jargon can be a real deterrent for consumers who want to invest their money wisely. They are also often too embarrassed to ask for an explanation and therefore either invest blindly or choose not to invest because they are unsure of what they are doing.
Novice investors are often overwhelmed by some of the jargon investing professionals use, to the point where it can feel almost like listening to or reading a foreign language, Abigail Wilson, business development manager at Morningstar South Africa, says.
There is no Duolingo edition that translates financial “industry-speak” to English, at least, not yet, but Wilson sat down to explain the most commonly used terms for consumers. She says these terms defined should at least serve as a starting point for novice investors or those sometimes left scratching their heads after reading a fund manager’s quarterly message.
Albert Einstein famously referred to the compounding effect as the eighth wonder of the world. Wilson says in short it means the longer you keep your money invested, the more likely it is to grow.
“Each year you have the opportunity to achieve growth, not only on the money you already invested, but also on the growth you already experienced within your investment, where you essentially earn “interest on interest”.”
She says think of your investment as a snowball, gathering magnitude as it rolls down a slope. The longer the slope or your time horizon, the larger and faster the snowball becomes.
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Equities, also known as stocks or shares, are what many investors first think about when it comes to investing, Wilson says. “When investors buy shares, they effectively become a part owner of that company, a shareholder. The reason stocks and shares are synonymous with equities is because owning a share of a particular company means you own equity in that company.”
As a shareholder, an investor benefits from any share price appreciation which is linked to the underlying earnings of the company, as well as any dividends the company pays.
You can buy equities in public or listed companies and sell them on a stock exchange, such as the Johannesburg Stock Exchange. Private Equity refers to ownership in a company not yet listed on a stock exchange, Wilson says.
“Over the long run, a well-diversified portfolio of equities is expected to generate sizeable returns above inflation. However, over the short term you must strap in and be prepared for a bumpy ride as share prices are often affected by a multitude of factors.”
She warns that along with their higher growth prospects, equities typically carry higher volatility in the short term in comparison to more stable assets such as cash and bonds.
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Bonds are usually described as loans to institutions, such as governments and companies, that need to raise capital to fund projects or initiatives, Wilson explains. “As a bond investor, you give your money to the government or company that issued the bond for an agreed period of time.”
In return, she says, the issuer (government or company) pays you a series of interest payments during the period of the loan. The annual interest paid on a bond is called a coupon. At the end of the agreed-upon period (maturity), the issuer repays the original face value amount that you loaned them.
“The bond yield is the total annual income you earn from bond coupon payments, stated as a percentage of the price of the bond. While providing a more predictable return than equities, bonds are not without volatility.
“Bond prices are sensitive to changes in market interest rates (in South Africa, the repo rate). An increase in the repo rate generally causes bond yields to go up and bond prices to go down. Typically, there is an inverse relationship, as higher interest rates generally cause bond prices to fall, and lower interest rates cause bond prices to increase.”
Wilson says bonds are typically used in investment portfolios to provide income and reduce overall portfolio risk when combined with equities.
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Diversification is an important investment strategy that spreads investment funds among different assets that are less correlated with each other, Wilson says. This approach helps to reduce risk while maximising return.
She says the best way to understand diversification is with an example: “It would be particularly risky to invest your entire life savings into a single company, taking a binary bet that the company is going to perform well and generate wealth.
“If that company performs poorly, you stand a chance of losing everything. Without diversifying, you would inherently be taking on increased company-specific, industry-specific and country-specific risks.
“By spreading your investment across several companies that operate in different industries and geographies, you are reducing these risks significantly and in effect creating a diversified equity portfolio.”
Wilson says this is an example of diversifying assets within a single asset class, namely equities. “A manager of a multi-asset portfolio will diversify even further by combining several different local and offshore asset classes, such as equities, bonds, money market (cash) and property in an investment portfolio.”
Therefore, multi-asset managers pay close attention to the most appropriate asset allocation for each strategy to reduce risk as well as maximise return.
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Wilson says you should think of asset classes as the different ingredients in a recipe and of asset allocation as the recipe itself.
“Asset classes are categories of investments. Very broadly, the four main ones are equities (also known as stocks and shares), bonds, property (listed real-estate investment trusts or REITs) and money market investments (including cash). Your allocation (%) to different asset classes is called your investment portfolio’s asset allocation.”
The asset allocation of your portfolio will be closely aligned with your risk profile and the financial needs analysis conducted by your financial adviser, she explains. The process of determining the correct asset allocation for your investment portfolio depends on numerous factors including, but not limited to:
Wilson says the asset allocation recipe varies significantly between a conservative investor, who is less tolerant of volatility and may have a shorter time frame and an aggressive investor, who seeks to maximise wealth growth and has the time to tolerate volatility.
This chart shows the asset allocation of a conservative portfolio, for an investor who has a shorter 3-year time horizon. The portfolio is made up predominantly of South African Bonds and Cash (money market):
This chart shows the asset allocation of a moderately aggressive portfolio for an investor who does not require the money for at least seven years. The portfolio has a significant allocation to local and offshore equities, but it also includes an allocation to bonds and cash to provide diversification and dampen volatility:
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Wilson says volatility marks how much an investment’s price rises or falls. “If an investment’s price changes more dramatically and/or more often, it is considered more volatile. During periods of heightened market volatility, equity prices will typically move up and down erratically from one day to the next.”
Price volatility is usually expressed in terms of standard deviation, or how much an investment’s price has fluctuated around its average price over a certain period. A higher standard deviation implies an investment’s price is more volatile.
This chart plots the annualized return (y-axis) and the standard deviation (x-axis) for SA Equities, SA Bonds and SA Cash over 15 years:
Investments with more uncertain outlooks, like equities, are typically more volatile, because equity returns are based on a company’s future profitability, which is difficult to predict, Wilson says. “In uncertain market environments, investors tend to be especially pessimistic about how businesses will perform, which can result in steep market declines.”
Why would you want to invest in a more volatile investment then? Because you are likely to be rewarded with a higher return over the long term, Wilson says.
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Volatility and risk are terms often used interchangeably, although they are very different. Risk should be defined as “permanent capital loss” or the chance that you will not meet your financial goal, Wilson says.
“For a retiree, your risk might be not taking on enough risk. By reducing your exposure to more volatile or “risky” assets such as equities, you could limit your portfolio’s potential return over the long run.
“By remaining in cash for prolonged periods of time you run the risk of increasing your tax bill significantly due to interest earned being fully taxable or losing purchasing power due to the eroding effects of inflation.”
Although a more equity-centric portfolio will experience more volatility in uncertain market environments, your asset allocation might not be overly risky, she says. “If you are far away from retirement, you have time to ride out your portfolio’s short-term volatility and take advantage of longer-term gains that equity markets tend to generate.”
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