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Investing demystified

It is said in investing to trust noboby... and think for yourself. In line with this advice, does this note attempt to clarify some of the concepts of investing, giving you the necessary understanding to make intelligent decisions regarding your money.

Work is what you do to earn money and make the world a better place. Investment is what you do with your money to make more money. In a non-capitalistic world would there not be such a word as investment.

PRIMARY INVESTMENT TYPES, AND THE BASIC TERMINOLOGY

- There are essentially only two primary types of investments in this world....
those that give a fixed / guaranteed GROWTH, being low risk and low return... generally referred to as the MONEY MARKET, and
those that don't give a fixed / guaranteed GROWTH, being higher risk and higher return... generally referred to as the SHARE MARKET.
In simple terms, you can either lend MONEY to an institution, or you can buy SHARES in the institution.

+ the first type is typically your savings/investment accounts at a bank, or bonds (and debentures) that is backed by some kind of surety, where INCOME is in the form of INTEREST which is guaranteed, and the CAPITAL is guaranteed
+ the second type is typically shares in companies (and properties), where INCOME is in the form of DIVIDENDS which is not guaranteed, nor is the CAPITAL guaranteed. Furthermore, as a business pays out more dividends, so the Capital Value will be less inclined to increase. Such types of investments may be in your own business, a friend's business (if you prepare to loose the friend), or unlisted companies, which make selling the shares rather difficult, hence increasing the risk element. One way to reduce the risk is to rather invest in listed companies (on a Stock Exchange) where your investment can quite easily be sold if you need the money.

Any other investment is merely some combination of the above two types, packaged and given a fancy name, under which to sell it.

- The INCOME element is specified as an AMOUNT (earned) which is more relevent to the first type of investment, whereas
the CAPITAL element is specified as an INDEX, which is more relevent to the second type of investment.
+ In both instances can the PERFORMANCE / GROWTH be expressed as a % Rate (of Return on original investment value, or Yield on current investment value).

This introduction was necessary to clarify the basic primary types of investments, and hopefully will the rest make more sense.

SECONDARY INVESTMENT TYPES, AND THEIR PURPOSES
These are not different investments, but merely 'vehicles' that invest in the Primary Investment Types. These investment vehicles mainly allow you to put your money in more than one investment, and in a combination of the MONEY MARKET and SHARE MARKET type investments.

TO REDUCE RISK THROUGH DIVERSIFICATION.
- One of the big problems with the higher GROWTH investments is that it carries a higher risk.... risk essentially referring to the fact that not only is your INCOME not guaranteed, but can your CAPITAL value also fall to the point where you can even loose all of it.
Generally the more an investment is in a specific field, the greater the risk. Risk is generally defined as the extent to which your GROWTH varies with time.... so, the longer your investment lies, and the less you need to cash in your investment the lower the risk.

- A person's propensity to risk depends on several factors, which range from...
+ a person's character .. some people are greater gamblers than others.
+ the age / time horison of a person .... the longer time you have before you need the money, the lower the risk.
+ the proportion of money in high risk investments..... the more money in high risk investments, the higher the risk.
+ the financial position of the person.... the more money you have spare, the lower the risk.

- One way to reduce risk without necessarily forfeiting GROWTH is to diversify your investments across a different number of entities and classes. Diversification reduces your risk with only a small reduction in your potential GROWTH.

- The concept of diversification has given rise to secondary types of investment vehicles called Unit Trusts (also known as Collective Investment Schemes, Mutual Funds, etc.). Although your Capital may be at risk depending on the primary type invested in, these are separate entities from the Investment Company so that in the event of liquidation of the investment compant, is your investment safe, hence the term "Trust".

+Alternative variations of the above are ....
*Exchange Traded Funds (ETF's).
In some ways similar to Unit Trusts investing in a range of primary investments, but not seperate from the Investing Company, so your investment is not secure if the investment company goes "belly-up".
*Asset Backed Securities (ABS's).
Invests in some "fixed" asset like gold, saving you from having to physically hold the item.

Although there are also admin charges, are the benefits gained from the professional management of your money greater than the costs, and should you instead focus on the GROWTH you can achieve, rather than merely the costs.
The PERFORMANCE of these funds are listed in many financial publications, and can be readily compared. This is probably the most effective form of investment presently.

TO REDUCE RISK THROUGH HEDGING.
Hedging takes diversification one step further, and involves placing some of your money in selected alternative investments whose performance may be directly opposed to the performance of your main investment. This makes the assumption that if your main investment under-performs, that your alternative investment will make up for it, and that you can't loose. These investment vehicles are known as Derivatives with names like Futures, Options, Warrants, Contracts For Differences (CFD's). The admin costs of these variations are quite high, when they get it wrong it can go very wrong, and is definitely not for the casual investor.

TO ACHIEVE OTHER OBJECTIVES THROUGH POLICIES.
Other secondary types of investment vehicle are policy types, which most often have some Tax Benefit like Endowments, Retirement Annuities (RA's), to encourage people to save for their retirement, or Assured Benefits attached to it, ie. a pension. These types often have a policy / contract between the parties, and require the money to be invested for a certain period of time. These types of secondary investment vehicles normally have rather high admin costs, the performance is not always transparent, and should only be considered if you have a specific need that can only be satisfied by such a policy type investment.

A WORD ON COSTS
As an investment option gets more sophisticated, for obvious reasons so do the costs associated with it increase.

TYPE OF COSTS
Costs can be for two periods, the one being the initial investment cost, and the other the ongoing cost.
Costs can go to two parties, the one being the Investment Institution which is generally not negotiable, and the other the Investment Advisor/broker/consultant which is negotiable.

WHAT ARE THE COSTS ?
These costs are normally very well hidden, and it is only in recent times that legislation in South Africa has forced investment businesses to show these costs, which is done as a %TER. Nevertheless, is it still nearly an impossible task to determine what exact costs are deducted from your investment.

ROLE OF COSTS IN YOUR INVESTMENT DECISIONS
However, one should not blindly look at costs as the only criteria for choosing a particular investment. One would hope the greater the costs, the greater the effort into managing your investment, so what's more important is the Nett GROWTH after COSTS (not forgetting RISK).
Although, high costs can turn an otherwise good investment over a long time into a bad investment.
Providing you have done your homework, and are clear on your requirements, can you totally do without an Investment Advisor/Broker/Consultant on certain simple investments.

Pierre Leon Myburgh

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