Why it is so important to make investments
24 February 2016
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Welcome to the latest edition of Old Mutual Live Business. My name is Chris Gibbons, invest, invest, invest is the cry from advertising hoardings to newspapers and TV and radio, but why? Why should we invest? What is the rationale behind investing?
We’re joined now by Professor Adrian Saville, Professor of Economics and Finances at GIBS, also Chief Strategist at Citadel Asset Management. Adrian, thanks for being with us again on Old Mutual Live Business. Start me at the very beginning on this one, why do I need to invest?
Two ways to to think about investing
Adrian Saville: Chris, thanks for having me on the show. That’s a fantastic question. There’s two ways that you can think about investing. The first way is to think about investing as one of the components of an economy. We talk about investment spending by governments and businesses and in the economic sense, this is really what investing is about.
It’s about putting capital into activities that become productive and that build the capability and capacity of an economy. We can think of investing in a manufacturing plant or we could think of investing in highways or we could think of investing in hospitals and schools. All of those would represent investment in a modern economy.
The other way in which the term ‘investment’ is used is in the way you and I might think about it as individuals or discuss it in our homes and here we talk about making an investment in a company. On the stock exchange or making an investment by putting cash into a bank account or making an investment by buying a unit trust.
All of these are referred to as financial investments and in that case, those financial investments, what they really represent is they represent us saving. By us saving, we’re putting money aside that we will use at some later stage.
It’ll always have some ultimate intended purpose, but the real point is that you and I are putting money away and that money will be used, either by us or by someone else, to make an investment that builds the productive capability and capacity of the economy.
Is investing more risky than saving?
CG: You’re telling me Adrian that investment and saving, pretty much the same thing. Is it really the case? Does not investment have an element of risk attached to it which perhaps saving does not?
AS: Well, if we go with that distinction and I think that that’s a very important distinction to make. If I say to you, I’ve saved R100 000 and I’ve saved R100 000 by putting it into a 12 month fixed deposit, then that saving will be used by someone else. They’ll go to the bank and they’ll borrow that money from the bank and they will convert it into their investment.
But for me, when I look at my bank statement, that bank statement should go up steadily, month after month as it accrues interest. So that investment into a bank account or that saving into a bank account is a very low volatility and therefore, by conventional measures, a very low risk investment.
By contrast, I could take that same R100 000 and invest it into a company listed on the Johannesburg Stock Exchange. Let’s take Old Mutual as an example and we could go and buy some shares in Old Mutual. That’s likely to be riskier because the company has to weather all types of challenges. Like change in economic circumstances, change in consumer appetite, they themselves have to try and manage currency volatility.
So there’s all types of things that make business difficult. If Old Mutual, as a business, manages these things well, then my investment in Old Mutual will be worth a lot more. If Old Mutual doesn’t manage these things well and loses their way and mis-steps here and there, then my investment could be worth a lot less.
For that reason, investments in companies are much riskier than investments in bank accounts or in cash savings accounts. For that reason, you should be rewarded more by taking the risk of investing in a company.
How to decide what is best for you
CG: So I have stocks and shares, I have cash, I have bonds, I have property, I also have alternative investments, things like art, carpets, stamps, things like that, how do I decide which is best for me?
AS: Well, I think the order in which you listed them might capture the relative riskiness. The lowest risk investment is widely regarded as being cash, it doesn’t bump around, it moves upwards steadily at the rate of interest that you’re earning. Perhaps next most risky is government bonds. Because what you have standing behind your saving or your investment is a government, which guarantees the capital.
The next risky is probably property because it has some element of being a business, but it also has some element of having a physical asset behind it. Perhaps more risky than that is companies listed on the stock exchange. Then further along the spectrum are some of the specialist investments that you described like wine or carpets.
If you’re a real expert in those, then that might be something in which you can make fair gains in. But for someone like me to go and buy a carpet, I would say that that would be an incredibly risky investment. So that’s the first thing, just to recognise that the distinction between the different asset classes and then to build a portfolio of assets that represent your investment horizon and your investment appetite.
I’ll give you a simple example; for my two young children, they’re 12 years old and nine years old, I have investments for them that are only companies listed on the stock exchange. The reason for this is they’ve got a very long time to be patient. They don’t have to worry that the investment bumps up and down on a month to month basis.
If you’ve got an asset class that can generate good returns in the long run and you can wait for that long run, then you can tolerate the bumpiness. If you are going to need access to your investment in the next month, then you don’t want it in a volatile asset class. You want it in an asset class that doesn’t bump around. In that case you’d want to allocate it to cash.
Which stocks investment route should you take
CG: If I do go into stocks and shares Adrian, do I buy individual shares or do I buy these things called unit trusts?
AS: Again, I think that that has to be answered on a case by case basis. You would need to establish the size of the investment amount that you have as well as your ability to build a portfolio. If you were telling me that you had R1 000 or R10 000, then I would say that the place that you should be looking at is a unit trust because the unit trusts will be managed by a person who gives you a diversified portfolio. So you’re not taking the risk of buying into a single company. It also allows you to get diversification with a relatively small amount of money.
If you’ve got a larger amount of money and now we might be talking hundreds of thousands or millions of rands, then you may well want to build a portfolio of individual names, but the same principles apply. You want to make sure that you’ve got a diversified portfolio and you also want to make sure that you have sufficient knowledge and ability to manage that portfolio. So this has to be answered on a case by case basis.
The importance of diversification
CG: Important word that you’ve used a moment ago, ‘diversification’, why is that important?
AS: Diversification really works in that it gives you the ability to weather changing or volatile conditions and I will give you a simple example. Imagine in the current circumstance where we’ve got collapsing oil prices. If you were invested in a single company that produces oil, you have gone from an environment in which not long ago you were getting $100 a barrel for your oil, today you’re getting $25 a barrel. Your industry that you’re working in has just gone into a horrible environment. You’re probably going to be losing money.
A single investment in an oil firm would be a horrible place to be right now, but if you had a portfolio, and here I’ll give you a very simple example of diversification, we don’t just have an oil business in our investment, we also put a vehicle company into the business and vehicle companies will probably find that demand for their cars goes up when oil and petrol prices fall.
So, at the same time that the oil company is going into difficult circumstances, the vehicle business is going into a better environment, meaning you get a counter balance. That’s the idea of a portfolio effect, is that when you get hurt on the one side, there is a different part of the portfolio that helps bring a benefit to another part of the portfolio.
CG: Adrian, final question, is this investing thing something I can do on my own or do I need to talk to an advisor or an expert?
AS: It is certainly something that you can develop the capacity to do on your own, but it requires an investment of time, it requires an investment in educating yourself. It also requires your ability to manage your emotions and to be able to interpret circumstances. You know, again, I think this needs to be answered on a case by case basis. But I would say for most people, you want to partner with an investment professional to help you build a portfolio that gets you from where you are to where you want to be.
CG: Professor Adrian Saville, Professor of Economics and Finance at GIBS and Chief Strategist at Citadel Asset Management, Adrian, thank you for being with me on Old Mutual Live Business.
AS: Thank you Chris.