What is investing?
Saving involves gathering together or hoarding funds, usually by setting aside a portion of each of your pay checks. By contrast, investing means buying financial assets such as shares, bonds, property or cash instruments in order to earn a profit and grow your wealth.
If you were to buy a house, for instance, you would hope that the value of the house would gradually increase over time, so that you could one day potentially sell it at a profit.
Likewise, if you buy shares in a company on the Johannesburg Stock Exchange (JSE), you hope that the value of the company - and therefore your shares - will increase over time, until they are worth more than you had originally paid.
This increase in value is called a capital gain. And while you wait for the right time to sell your shares, the company may further reward you for being an investor by paying you dividends, or shares of its profits.
Investing is key to creating wealth and reaching your financial goals, such as ensuring that you have enough money to live off when you retire.
Types of investments
As previously mentioned, there are a variety of different types of investments or asset classes available. These include:
Shares or equities
A share represents a portion of ownership in a company. Companies issue shares to raise money to grow their businesses, which is then bought and sold by investors on stock markets such as the Johannesburg Stock Exchange (JSE). When an investor buys a share in a company, they are purchasing a portion of the company’s profits (or losses), which is why these investors are referred to as shareholders. The terms shares and equity are used interchangeably. They are also known as stocks.
So if you were to buy a share, stock or equity in Mr Price, this would all mean the same thing – that you own part of the company. If Mr Price then (hopefully) grew its business, it would pay you dividends each year, and eventually you might be able to sell your shares at a profit.
A bond is a financial tool that is used by governments, local authorities, SOEs and companies to borrow money from investors. When an investor buys a bond, they essentially provide a loan to the bond issuer (the government or entity that created the bond). As compensation, investors usually then receive regular interest payments from the bond issuers in return.
These interest payments cease on the bond’s maturation or “expiry” date, on which day bond issuers promise to repay investors the original amount loaned.
For instance, if you invested R1,000 in a 5-year RSA Fixed Rate Retail Savings Bond with an 8.5% yield, you would receive R85 (8.5% x R1,000) in interest each year for five years. At the maturity date, you would also be repaid the original R1,000 investment amount.
There are many ways to invest in property, beginning with buying your own home or investing in a buy-to-let property and becoming a landlord. However, you don’t have to invest in a bricks-and-mortar house to invest in property.
Other options worth considering include investing in listed property, either through a real estate investment trust (REIT) or a property exchange-traded fund (ETF), which are both accessible via stock exchanges.
A REIT is a company that owns and often manages income-producing real estate, while a property ETF tracks the performance of various listed property companies.
Cash investments can refer to investing money in high-interest or fixed-deposit bank accounts, or investing in a money market fund which may hold Treasury bills, commercial papers, short-term certificates of deposit (CDs) and short-term bonds with maturation dates of less than a year.
However, while cash investments offer greater capital protection and lower risk, it also offers lower returns than other asset classes, and is generally not suitable as a long-term investment if you want to defeat the value-eroding impact of inflation.
What are the risks?
While investing can earn you money, it also carries risks. The greatest risk is that you will lose your money, because unlike bank savings accounts where your capital or money is guaranteed, investments do not carry guarantees.
Take the example of Steinhoff - on 23 May 2017 Steinhoff shares were worth R50.25 each, but by 11 May 2018, just a few months after its collapse, these shares were worth only R1.60 each.
That said, some investments are far less risky than others, and the amount of risk you are willing to accept will impact your potential returns. An investor who takes on more risk is may earn greater rewards over the long term than an investor who opts for less risky investments.
Practically speaking, no-one would take a risk without the possibility of a big pay-off.
Your investment time horizon
Time and risk go hand in hand, because the longer the period an individual has to invest, the more risk they are generally willing - and able - to take.
Consequently, one of the biggest factors influencing where you should invest your money is your time horizon, whether this be one year, five years, 10 or even 20 years.
For instance, a short-term investor who only has a year or two before they will need to access their funds will generally prefer less exposure to risk, and rather emphasise safeguarding their funds.
They might then choose to invest their money in a cash-based investment such as a money market fund, or a high-interest savings account. These types of investments carry very low risk, but also offer very limited returns.
By contrast, a long-term investor might consider investing in shares in the stock market. Historically, shares have generally delivered far greater returns over time than cash investments. However, the value of shares tends to be far more volatile in the short-term, experiencing moves both up and down.
This is why stock markets are generally more suited to investors with an investment horizon of at least five years, if not longer, to successfully ride out different market cycles and see positive returns.
For example, in the 12 months to the end of December 2018, the average SA Equity General portfolio (which hold at least 80% of their investments in shares or equity) delivered negative returns of -8.8%. By comparison, the average SA Money Market portfolio achieved positive returns of 7.3% in the same period.
Over the ten years to the end of 2018, however, the average SA Equity General portfolio achieved handsome returns of 10.5%, where SA Money Market portfolios delivered returns of just 6.6% - barely above the rate of inflation at 5.4%.
Sector performance comparison
So, while past results are no guarantee of future returns, by matching your time horizon and goals with your investments, you will be able to maximise your chances of success.
Reducing your risk
Investors can reduce their overall investment risk through diversification, or by spreading their risk across different types of investments.
This means investing across the different asset classes - shares, property, bonds and cash - as certain may perform better than others under different market conditions. For example, during periods of heightened volatility, share portfolios suffer some losses while other investments might deliver good results.
You can also diversify your investment portfolio by investing in different geographical regions, sectors and industries.
By avoiding placing all your eggs in one basket, you will be able to reduce your potential for investment losses, and smooth out your overall returns.
Ultimately, there are hundreds of different financial products available to investors looking to put their money to work and build their wealth, all with different characteristics and tax implications.
This article was published on the BusinessTech Website on 11 January 2020.