If you feel you’ve invested enough in yourself and your debt is under control, it’s time for the next decision:

Which asset class?

Let’s leave the alternative asset classes like hedge funds, derivatives, commodities (e.g. gold), private equity (e.g. venture capital) and collectibles (e.g. art and coins) out of the picture for now and start with the basics – the traditional asset classes:

1. Money market (cash)

Put simply, this is where you sell your money to an institution in return for interest and the repayment of the loan within one year. Depositing your money in a savings account is a money market transaction. So is pooling your money with other money market unit trust investors, which allows you – through the trust – to buy a variety of cash-like instruments that are not normally available to individual investors.

Looking at the data in Triumph of the Optimists, the money market has returned about one percent more than inflation per year, on average, over the past century. But if you’re a tax-payer and younger than 65, you’re currently taxed on all interest above R19 000 per tax year. If you’re investing large sums, you could therefore be left with a return that’s not even keeping up with inflation. On the other hand, money market is the most stable of all investment options (the value of your investment doesn’t fluctuate much).

The money market is therefore great for those who:

• Need a short-term parking bay for their money
• Invest small amounts on which the interest will be less than the R19 000 annual tax threshold
• Can’t stomach the volatility of the other asset classes
• Have a more pessimistic view of world markets and believe that the historically better investment returns of the other asset classes won’t be repeated over the next few decades.

2. Bond market

Like the money market, this is a market in which you lend your money in return for interest, but the term of the loan is usually much longer. And there’s no guarantee that you’ll get back the same amount as your capital invested, as the capital value of the investment fluctuates. The borrowers could be governments or big corporates raising finance through bonds rather than issuing more shares. Usually, the higher the interest rate being paid, the higher the credit risk of the borrower. Credit risk indicates the likelihood of the borrower not being able to repay the debt.

Over the past century, the bond market has, on average, returned about two percent more than inflation per year before tax. (The tax on income from bond instruments works the same as for the money market.) But the uncertainty of return is much higher than in the money market. For example, during the first six months of 2008, our All Bond Index returned -6.7%.

The bond market is perhaps more appropriate for investors who understand credit risk and the impact of interest rate movements on the bond market very well. Less experienced investors who want a slightly higher return than money market may want to out-source the decision between money market and bond market to flexible income unit trust managers. Their job is to analyse the prices of money market and bond market instruments, and then invest in those that they think offer the best value for money. As a result, the portfolio is often exposed to the best of both asset classes.

3. Property market

If investing directly in property, you earn income in the form of rent and hopefully also see some capital growth (an increase in the property’s value). Your return on your investment is a combination of these two factors. Property indices returned about five percent more than inflation per year, on average, over the past few decades. Property prices can also decline for uncomfortably long periods, but they are not as volatile as equity prices.

Unfortunately, this market has high minimum investment amounts (not many properties left under R500 000). Most people therefore have to get a mortgage and it can take quite a few years before the rental income exceeds your bond repayment, levies and taxes. Direct property investment is also relatively illiquid. In other words, it could take a while before you are able to sell at a reasonable price. Alternatively, if you want to use less capital, you can opt for a property unit trust (PUT) or buy units in property loan stock (PLS), where you pool your money with other investors also wanting exposure to the property market.

4. Equity market

Here you buy a share in one or more companies. When they make a profit and don’t need the earnings to expand the business, they pay you a dividend. Hopefully, your share price will also increase as the company grows, but share prices can be much more volatile than bond or property prices. Your return on investment will be a combination of the dividends received and the change in the share price. Over the past century, equity markets have returned about seven percent more than inflation per year, on average. But over the short term they could lose a lot of value – as much as 50% or even more.

A 10% tax on dividends is in the pipeline, but this will only replace the current secondary tax on companies (STC), which is also 10%. The net impact on shareholders should be the same.

The equity market suits those who:

• Don’t need the capital within the next 10 years
• Can stomach volatility of share prices
• Believe that markets haven’t changed structurally and that the equity market will continue to be the best performer over the long term.

5. Offshore markets

The South African equity market forms only 1% of the world market and investing internationally can be a great way to diversify your portfolio. And the more the rand depreciates, the more your investment is worth in rand terms.

But if you only invest offshore, you should prepare for some turbulence. Even if you invest in the stable money market offshore, you will witness the rand value of your investment zig-zag from one day to the next. That’s because the exchange rate is so unpredictable over the short term. If you therefore invest offshore in a more volatile asset class like equity, you could see even bigger changes in the rand value of your investment. Over the long term, in theory at least, the rand is suppose to depreciate against the major world currencies at a rate equal to the difference between our inflation and the inflation in their countries.

Back to our question: Which asset class?

If you will need your savings within the next year and tax is not an issue, the money market is your safest option.

If you have money you won’t need within the next 10 years, and you want to diversify your portfolio, you may be interested in all three of the riskier asset classes, i.e. property, equity and offshore assets.

If you think you’ll need the money within the next two to 10 years, your decision becomes tougher. A flexible income or a low-equity portfolio (no more than 40% in equity and the rest in money market) should provide a slightly higher return than the money market – if you stay invested for a few years. More equity in your portfolio increases the volatility of your investment, but also the potential for a higher return.

While a whole century of performance data for each asset class shows the long-term picture, it unfortunately can’t guarantee your future return.

Tags: asset classes, bonds, equity, money market, offshore, property, Triumph of the Optimists

This entry was posted on Monday, September 22nd, 2008 at 9:31 am and is filed under Money matters. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.