INVESTING AND TRADING Build a solid foundation for your share portfolio Shaun van den Berg Head of Client Education PSG Wealth
A solid investment foundation is crucial to achieving long-term success. In the words of author Stephen R. Covey: ‘If the ladder is not leaning against the right wall, every step we take just gets us to the wrong place faster’. When it comes to sensible long-term investment decisions, it pays to stick to the basics.
Building a share portfolio takes time A share portfolio is built over a period of time – it does not happen overnight. The first thing to consider is whether you want to invest a lump sum in a wide variety of shares, or to invest in fewer shares on a monthly basis. Buying shares on a monthly basis will involve higher relative trading costs since these costs are spread across the amount invested. Having fewer shares in your portfolio means you also have to be confident in your stockpicking ability. If you only own one share, there is a 100% chance of losing money if the price of that share drops. As you add to your share portfolio, the chances of capital loss drop to 50% with the second share, 33.3% with the third share, 25% with the fourth share, and so on.
Diversification reduces risk Every investor should aim to build a well-diversified portfolio of quality shares. Diversification in a share portfolio refers to investing in various companies across different sectors and industries, thereby reducing your exposure to risk. In an effort to reduce risk, you may decide to spread your investment over eight to twelve shares and across three to five sectors. Ideally your investments should be across sectors with low correlation to one another. In other words, you should invest in industries and sectors that do not move up and down at the same time or at the same rate when market conditions change. By combining different shares, you are less likely to experience major losses. When the price of some of your shares drop, there’s a good chance that others will be on the rise. This provides a more consistent overall performance.
A diversified portfolio is still subject to market risk While minimising risk is important, you need to consider it together with another investment objective, namely achieving better investment returns than the market average. No matter how diversified your share portfolio is, you can never eliminate risk completely. You may avoid the risks associated with individual shares (‘unsystematic risk’) by diversifying your portfolio, but there is still a risk of an overall market correction (‘systematic risk’) that can affect most of your shares.
A diversified portfolio may dilute investment returns If you are invested across five sectors, and one performs exceptionally well, your gains will be diluted compared to if you were invested in that one sector alone. The more extensively diversified a share portfolio, the greater the likelihood that its performance will therefore, at best, reflect the performance of the overall market. It is a continuous process to manage the balance between concentration in certain shares and sectors, and the diversification of your portfolio.
Guard against over-diversification One of the advantages of a more concentrated share portfolio is that while it does increase risk, it also increases potential reward. Share portfolios that deliver the highest returns are typically not widely diversified, but rather have investments concentrated in a few carefully selected industries or market sectors that outperform the overall market substantially. A more concentrated portfolio also enables investors to focus on a manageable number of quality shares.
Decide on an appropriate investment strategy Once you decide on the structure of your share portfolio, the next step is to decide on an appropriate investment strategy. An investment strategy is a set of principles to guide you in selecting appropriate shares to include in your portfolio. Below we explain some of the most common investment strategies which can be used individually, or in combination with one another. • Value investing Value investing can be described as bargain hunting, because it involves looking for shares that are undervalued (compared to certain valuation metrics in fundamental analysis), and buying them for less than what they are worth. The value investor will look to benefit from the profit by selling the share when it reaches the value they have predetermined to be its true value.
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INVESTING AND TRADING
• Growth investing With capital appreciation as the main objective, growth investing focuses mainly on companies that show signs of above-average growth. These companies’ share prices often appear expensive based on their price-earnings or price-tonet asset value ratios. • GARP (growth at a reasonable price) investing GARP investing is a combination of the value and growth strategies, offering the best of both worlds. It involves investing in companies that are somewhat undervalued but still have solid sustainable growth potential. • Income investing The aim of this strategy is to generate income by investing in shares that pay relatively high and regular dividends. These are usually shares in well-established, mature companies with a long track record of regularly increasing dividends.
We are all unique – your strategy should be too Investors have different investment objectives and skills, which means that certain tactics and strategies will be more appropriate for some investors than for others. The challenge is to focus on achieving returns that are better than the overall market, with a level of risk that you find palatable.
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