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A Roadmap for Getting Started in the Market

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“So what exactly is your methodology? If you cannot answer that question, you are not ready to be risking money in the markets” J. Schwager

Note: This is not a guide on financial planning but rather some ideas about growing capital in the equity market. Investing carries risk and when starting out it’s best to manage just a portion of your savings yourself.

Step 1: Establish the right mindset:

Many newcomers approach investing with the wrong attitude. They see their role as predicting whether a share is about to go up or down. For a novice investor this is a recipe for disaster.

Successful investing is a process and has more to do with risk management than making predictions. Every investment carries risk, and that includes investing in cash. The risk with holding cash is that inflation will erode the spending power of that cash. The risks of owning a share are numerous, depending on the company itself, the sector, the market, the price you pay and your investment time frame.

To grow capital you need to follow a process of making decisions that improves the odds of outperforming inflation. Every time you take action you should be trying to put yourself in a better position than you were in previously.

Step 2: Asset allocation:

The first step in this process is asset allocation. The basic asset classes are equities, cash, bonds, property and commodities. For simplicity’s sake we are only going to look at equities and cash at this stage. We will investigate the pros and cons of adding bonds, property and commodities later.

The following chart compares the performance of $100 dollars invested in equites vs cash in the UK market over the past 100 years. The cash rate is actually the rate for three month treasuries, but it’s close enough. If you look at most markets over long periods of time the pattern is the same.

Image: Princeton University Press

Princeton University Press

To grow savings, the most important decision you will make with your saving is to invest a significant portion in the broad equity market, rather than keeping it in a bank account. That decision will probably have a bigger effect on your net wealth than any subsequent decision. Unless you actually

manage to pick the next Warren Buffet or the next Google, the investment returns you make by investing in individual shares or active managers will probably only add a fraction of the performance you’ll get by just being in the market.

When we say ‘broad equity market’ we are talking about an index. An index is a portfolio of shares that represent a market or a sector of a market. Most indices are weighted by market capitalization which means that the companies with the largest value (by market capitalization) have the biggest weight in that particular index. This also means that as companies grow, their weight within the index will also grow. By investing in an index, you will always be exposed to the largest companies in the market.

The two most common methods of investing in an index are via index tracking unit trusts and ETFs. An index tracking unit trust is a collective investment scheme that tracks the index by investing in the same shares and in the same quantities as the index it is tracking. An exchange traded fund (ETF) is itself a listed share with the sole purpose of owning the shares that make up an index. Both vehicles charge a management fee, but ETFs usually have lower fees. You would buy unit trusts from an asset manager or via a unit trust platform. You can buy ETFs via a stock broker, or sometimes directly from the issuer.

What percentage should you invest in equities?

There is an old rule of thumb that says you should invest 100 minus your age in equities and the rest in bonds and cash. So if you are 30 you would invest 70% in equities and 30% in bonds and cash. This means that the older you get the more capital you invest in ‘safer’ assets. This is not very scientific, and given increasing life expectancies is also a bit out of date, but it’s a good starting point.

A more pragmatic approach would be to consider the amount of cash you may need access to in the next five years and keep that in cash.

Finally, the psychological test. In 2008 the JSE Top40 index fell 50%. Imagine you had all you capital in the market – maybe you did. Now imagine how you would have felt about losing 50% of it (even if only on paper). If you would have considered selling out to stop the pain, then you were probably over exposed. Drawdowns, or losses, in capital will occur and you need to be able to live with them.

As mentioned this is not an article on financial planning. This is about growing capital in the equity market. The point on asset allocation is that committing money to equities is the first and most important step you will take. Any action you take over and above that will probably add only marginal gains. The initial commitment to hold equities will however make a significant difference.

Step 3: Add strategies that are likely to improve your returns over time:

The only reason to make a change to the above allocation is if that change is more than likely going to have a positive impact.

Broadly there are three reason to make changes:

  • To improve the expected return.
  • To diversify risk.
  • To lower expected volatility.

The third step is not something to jump into. This is something to approach cautiously and incrementally.

Before asking yourself whether you should invest in another strategy or in an individual share, you should ask yourself what is most likely to happen if you don’t invest in it. Then ask yourself what will happen if you do invest in it and it turns out to be wrong. You need to have a positive expectancy before investing in an alternative.

We will look at some practical examples for implementing an investment plan in part 5.

Step 4: Benchmark yourself

All fund managers have some sort of benchmark, and so should you. You need some way of measuring yourself. For most equity funds the index will be an equity index. For some funds which aim for absolute returns the index might be an interest rate, an inflation index or an inflation index plus 3% or 6%.

If you don’t believe you can outperform an index, you should invest in an ETF tracking that index, or a mutual fund aiming to outperform it, and leave it at that. But if you do believe you can, you need to keep track of how you are measuring up.

As long as your own portfolio is under-performing your benchmark index, you may as well keep the bulk of your equity allocation in that index. The more you can prove to yourself that you can consistently out-perform an index the more you can allocate to your own investing activities

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