Compiling Your Investment Portfolio
Overview
At this stage you have gained a better understanding of what shares are and how you can begin to invest in and benefit from them.
Part of the process of investing is putting together an investment portfolio. This step is vital as it helps you to manage the risk linked to investment.
This module will identify the steps you can take in putting together an investment portfolio so as to manage your investment risk.
Cautious and Aggressive Investors
As mentioned before, investing is all about the balance between risk and return and you were asked to consider some of the factors that influence your risk appetite. If investors were to be grouped into two broad categories with regard to risk appetite, cautious and aggressive investors would be described as follows:
Cautious Investor: is typically one who is more focused on moderate returns which have a higher chance of being realized. This type of investor is most interested in what is safe, secure or tried and tested. They understand that their lower appetite for risk has an impact on their expected return and are prepared to skip some of the superior rewards for more certainty.
Aggressive Investor: usually has a much higher pain threshold – they are more comfortable with high levels of risk. They can afford to or are prepared to risk much more and as a result of this they stand to reap the big rewards. They also have to brace themselves for the downside of the risks they take.
Once an investor is clear on their investment goals and risk appetite, there are numerous shares listed on the JSE that match specific investor goals and risk preferences. It is useful for you to decide which type of investor you are before putting your portfolio together.
Picking Shares: Size & Market Cap
There are a variety of ways in which shares can be classified – on the basis of size; on the basis of track record and solid earnings; or on the basis of industry.
Size and Market Capitalization
Regarding size, shares are commonly referred to as small, mid and large cap shares. ‘Cap’ is short for capitalisation.
Market Capitalisation is determined by multiplying the current market price of a share by the number of that company’s shares issued. This means that if a company has issued 1,000,000 shares and they are each valued at R20 then the market capitalisation of the company is R20,000,000.
A common mistaken belief is that the share price indicates how big the company is. This is not necessarily true. For example, company A could have a higher share price of R100 per share in comparison to company B that has a share price of R20 per share, but company A may only have 1 million shares while company B has 10 million shares. In effect, company A would have a market value of R100 million while company B is valued at R200 million.
Market capitalisation is important to consider as an investor because it gives insights into a company’s potential for growth as well as their propensity for risk.
Small cap companies have traditionally experienced much higher growth potential but they tend to face more risks than large cap companies. Large caps usually experience lower capital growth but also experience more stable share prices or less price risk.
It must be noted that a company’s market cap is not a constant number – it changes as the share price changes (remember the calculation for market cap).
Picking Shares: Market Sectors & Industries
Out of all the companies listed on the JSE, most belong to the Financial, Resources and Industrial sectors.
There are too many companies listed on the JSE to provide a complete outline of which sector each company falls into.
Recognizing who the market leaders are across the different sectors and industries helps you as an investor when trying to pick shares to invest in.
Some investors take the approach of first understanding the economy better rather than the individual businesses. When they look for opportunities they start by getting a bigger picture of the economy and current conditions.
They then investigate which sector or industry may be best positioned in the current economy to benefit and grow or thrive in that environment. When they have spotted a sector, they identify a company or specific share to buy. This is often called the “top down” approach to picking shares.
Remember that past performance is not always a reliable indicator of future performance, but it may provide a benchmark of what to look for.
Diversification
Diversification is a method that many investors use to reduce the risk in their portfolio as a whole.
One of the best ways to diversify is to make ensure that a portfolio consists of shares in a variety of sectors and not shares of different companies that are all within the same sector. For instance, investing in shares in Mr Price, and The Foschini Group would be investing in different companies but within the retail sector alone.
Taking this concept one step further suggests that investors should not put all their money into one asset class. Shares form part of one type of asset class (in the equities market) – other asset classes include bonds (fixed-income financial instruments), money markets (cash or cash equivalents) and commodities (like gold, platinum and oil).
Spreading investments across different asset classes is referred to as asset allocation, which involves finding the right mix or balance of each. Asset allocation can add to a diversified portfolio and enable the investor to match their needs even better.
A diversified investment portfolio may well have investments in all three asset classes – the proportions of investments in each asset class (that is, the weighting) would depend on the investor’s risk appetite, investment goals and age.