University of Cape Town

Department of Finance and Tax

Personal Financial Management (FTX2000S)

MODULE 4
Investment Planning

For This Week: Study Sections 3 and 4 on pages 16 to 25

Table of Contents
TABLE OF CONTENTS ........................................................................................................ 2
1. INTRODUCTION ............................................................................................................ 3
2. THE PRINCIPLES OF INVESTING ..................................................................................... 3
2.1 HOW ARE INVESTMENT RETURNS DEFINED AND MEASURED? ....................................................... 4
2.1.1 Holding period returns ............................................................................................................ 4
2.1.2 Arithmetic and geometric returns .......................................................................................... 5
2.2 NOMINAL VERSUS REAL RETURNS ............................................................................................ 7
2.3 HOW IS INVESTMENT RISK DEFINED AND MEASURED? ................................................................. 7
2.3.1 Measuring uncertainty............................................................................................................ 7
2.4 THE RELATIONSHIP BETWEEN RISK AND RETURN ......................................................................... 9
2.4.1 Calculating and comparing risk-adjusted returns ................................................................. 10
2.5 INVESTMENT PORTFOLIOS AND DIVERSIFICATION...................................................................... 10
2.5.1 The principle of diversification ............................................................................................. 11
2.6 DETERMINANTS OF INVESTMENT SUITABILITY .......................................................................... 12
2.6.1 The impact of the financial life cycle on investment objectives ........................................... 13
2.6.2 Investment considerations and pitfalls ................................................................................. 13
3. FINANCIAL MARKETS .................................................................................................. 16
3.1 THE CAPITAL MARKET .......................................................................................................... 16
3.1.1 Shares ................................................................................................................................... 16
3.1.2 Bonds .................................................................................................................................... 17
3.1.3 How are capital market investments traded? ...................................................................... 19
3.1.4 The costs of investing ........................................................................................................... 20
3.1.5 Active versus passive investments ........................................................................................ 20
3.1.6 Interpreting information in the financial press..................................................................... 22
3.2 THE MONEY MARKET........................................................................................................... 22
3.2.1 Fixed deposits ....................................................................................................................... 22
3.2.2 Money market accounts ....................................................................................................... 23
3.3. CAPITAL MARKET HISTORY................................................................................................... 23
4. SUMMARY ................................................................................................................. 25
5. REFERENCES ............................................................................................................... 25

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1. Introduction
The goal of achieving financial independence is one that seems out of reach to many
hardworking individuals with limited incomes. What many do not realise, however, is that
regardless of income stream, sound financial planning is not only a possibility, it is a crucial
element of achieving a suitably comfortable retirement. Investment planning has an
important role to play in this process and is often overlooked because it is seen as extremely
risky, highly complex and therefore out of grasp for the ordinary individual. This is definitely
not the case.

It should be noted that the investment environment is complex and characterised by

numerous markets, each comprising thousands of distinct instruments and governed by
specific regulations. As such, this topic is broad and much of the technical detail is beyond
the scope of a course of this nature. This module will endeavour, however, to demystify
some of the common misconceptions around investing and provide enough background to
the topic to enable you to better grasp the fundamental principles underlying investing.

For the purposes of this module, investment planning can be defined as the evaluation and
selection of financial assets to form an investment portfolio with the goal of meeting an
individual’s longer-term financial objectives. These objectives will typically include meeting
such financially significant obligations as providing for your children’s educations or ensuring
that you are financially secure at retirement.

In this module, you will:

 Explore the concepts of risk and return as they pertain to individual investments and
investment portfolios (section 2).

 Learn about the factors that impact on the decision of which investments best suit
your needs and objectives (section 2).

 Be introduced to financial markets and the primary investment instruments that

trade within them (sections 3 to 5).

 Examine the historical risk and return of shares, bonds and money market
investments in South Africa (section 6).

2. The principles of investing

All individuals have financial needs and obligations. Where their incomes exceed these
requirements, they have excess means and are able to save now in exchange for increased
future earnings. There is therefore a trade-off between lower present spending and higher
future spending. The reward for deferring spending to some future date is measured by
some rate of return earned over the period.

Practically speaking, this trade-off is encapsulated in the relationship between present

values and future values as discussed in module 2. Key determinants in this relationship
between the present and future values of money are inflation, opportunity costs and risk.

Investment can be defined as the saving of current income for a period of time, in exchange
for a return that provides appropriate compensation for the time over which spending is

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deferred (the opportunity cost of investment), the uncertainty around the return (the risk)
and the expected inflation in the market.

Such investments are typically accomplished by buying and selling financial assets. When
financial assets are referred to, they will be intangible assets, typically traded, which have
the capacity to generate wealth over time. Common examples would include shares
(sometimes referred to as equities or stocks), bonds and other forms of fixed income
securities and derivative instruments.

2.1 How are investment returns defined and measured?

The return on an investment is simply a measure of the gain or loss on the investment. One
can distinguish between two components of return. The income component comprises any
cash received over the investment period as a consequence of holding the investment. The
capital component represents the change in value of an investment over time and is
typically only realised once the investment period ends. Not every investment has both an
income and capital return but the total return on any investment will comprise one or both
of these components.

Investment returns are normally express as a percentage rather than a rand figure. This
facilitates the comparison of performance between investments of different sizes.

Note: The examples to follow will employ shares to demonstrate a number of fundamental
investment concepts. Some of the terms used may be unfamiliar to you, but they will be
clarified in section 3, which covers shares in greater detail. For now, it is most important that
you grasp the principles of risk and return being illustrated without being caught up in the
finer details of how shares work.

2.1.1 Holding period returns

You own shares in company A, which you purchased at the beginning of the year for R100.
During the course of the year, you receive a dividend of R5 from the company. The value of
your investment at year end is R120. You also own shares in company B, purchased at the
beginning of the year. The initial cost of the shares was R400 and by year end they had
increased in value to R440. Company B does not pay dividends. What has the return on your
investments been over the year?

We can visualise the scenario as follows:

R20 increase in price (capital gain)

Company A: R100 R120
R5 dividend (income)

R40 increase in price (capital gain)

Company B: R400 R440

For company A, the dividend received is an example of an income component of return,

while the change in the value of your investment over the year represents the capital
component of return (referred to as either a capital gain or a loss, depending on whether
the price has increased or decreased). The total return on your investment in rand terms is
therefore the sum of the two: R5 + R20 = R25. In percentage terms, you have received a

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total return of R25 on an initial investment of R100. Your percentage return is therefore
R25/R100 = 25%.

For company B, you only have a capital gain over the year. This is an amount of R40 on your
initial investment of R400. Therefore, the percentage return is R40/R400 = 10%.

Note that if you had compared the investments on the basis of their absolute rand returns,
company B would appear to be the better investment as it yielded a return of R40 relative to
the return of R25 for company A.

Comparing the investments on the basis of their percentage returns, however, company A
had a return of 25% versus the return of 10% for company B. This is because, even though
company A yielded a lower rand return, you invested far less money in company A in order
to achieve your return. In hindsight, it may have been better to invest more money in
company A than company B to maximise its higher returns!

The returns calculated above are referred to as “holding period returns”, and represent the
return over the specific period for which the investment has been held. A holding period
return does not necessarily need to be calculated only on an annual basis. For example,
assume that you hold your shares for a further year, company A pays a further dividend of
R8 and its price at the end of the next year is R118. What is the holding period return on
company A in the second year? What is the holding period return over the two years?

The holding period return in the second year is based on a capital loss of R2 (remember that
the new price is R120 at the beginning of the second year) and a dividend of R8:

–R2 decrease in price (capital loss)

Company A: R120 R118
R8 dividend (income)

Therefore, the holding period return for the second year is: (–2 + 8)/120 = 5%.

In contrast, the holding period return over the two years takes into account the capital gain
(or loss) over both years, plus any dividend income received.

R20 capital gain – R2 capital loss

Company A: R100 R118
R5 dividend + R8 dividend

The holding period return is therefore: (20 -2 + 5 + 8)/100 = 31%.

It is important to note that the holding period return over the two years is not simply the
sum of the returns in each year. In our calculations above, the holding period return for the
first year is taken relative to the starting price of R100, while for the second year it is taken
relative to the new price, at the beginning of that year, of R120.

In contrast, the holding period return over the full two-year period is calculated relative to
the initial price of R100.

2.1.2 Arithmetic and geometric returns

It is sometimes useful to calculate an average return on an investment over a period of time.
This provides an indication of how the investment performed, on average, over each of a
number of investment periods. For example, company A had a return of 25% in the first year

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and 5% in its second year. What was the average return from the company in each year? The
simplest way of estimating this is to take an arithmetic average of the two returns.

The arithmetic average of a series of values is simply the sum of those values, divided by the
number of values over which you’re averaging:

Where is the arithmetic return, to are the returns in each period and is the
number of periods for which the average is being calculated. Using the example of company
A, the average return for the company in each year would be:

An arithmetic average is appropriate where you believe that the returns in each year are
independent of each other. In other words, the return in one year does not influence the
return in the next. In finance, this is often not the case. Consider our example for company
A. In the first year, you had return of 25%, which increased the value of your investment and
meant that you had a larger capital base from which to grow your returns in the following
year. You could, for example, take the dividends you received and re-invest them to earn an
additional return. In contrast, had you instead suffered a loss on your investment or not
received any dividends, you would have had a smaller capital base from which to earn
further returns in the second year.

It is fundamental that you recognise that the arithmetic return does not take into account
the impact and power of compounding on your investment returns from one year to the
next. An alternative to calculating the arithmetic average is to calculate a geometric return.
A geometric return takes compounding into account and is a more appropriate measure of
assessing the past performance of your investments.

The geometric average of an investment’s returns is calculated as per the following

equation:

For company A, the geometric return is:

Note that the geometric return is less than the arithmetic return. This will always be the case
as the geometric return takes compounding into account. This means that a lower return is
required to grow your investment than is the case for the arithmetic return, which does not
include compounding.

You may be wondering when it is appropriate to use each of the measures. The geometric
return is typically used when assessing and comparing past investment performance. The
arithmetic return is most appropriate as an indication of what to expect in future (assuming

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that you don’t expect returns for that investment to change significantly in future). As it
assumes the returns in each period were independent of each other, it makes no
assumptions regarding compounding and you should, therefore, consider it an unbiased
estimator of performance.

2.2 Nominal versus real returns

It was established in module 2 that inflation erodes the purchasing power of money over
time. It impacts equally on returns and a distinction must be made between nominal and
real rates, when discussing investment returns. Nominal rates of return are the actual
returns observed on investments over a period of time. In other words, they are returns that
have not been adjusted for inflation. The holding period returns calculated in sections 2.1.1
and 2.1.2 are nominal returns. Real returns are investment returns that have been adjusted
for the impact of inflation. In the presence of inflation, real returns will be less than nominal
returns.

Ideally, investments should always have positive real returns to ensure that your investment
growth is outpacing inflation in the market. If the real returns on your investments are
negative, this indicates that even though your investment value may have grown over the
period, the growth was not sufficient to compensate for inflation. You have therefore lost in
real terms.

As a rough rule of thumb, you can estimate real returns by simply subtracting the inflation
that prevailed over the investment period from the nominal return earned over that period.
For example, assume you earned a nominal return of 11% on some investment over the past
year. If inflation over that period was 5%, the real return on the investment would be
roughly 6%.

2.3 How is investment risk defined and measured?

You might ask what determines the return of an investment. While there are many factors
that can impact on investment returns, the primary factor is the risk of the investment.

Whenever you invest a sum of money, you do so with the expectation that you will earn
some form of return in exchange for your investment. In a few specific instances, you will
have certainty as to the exact return you can expect to earn. For example, if you deposit a
sum of money into a fixed deposit with a bank, you will know from the outset exactly what
the interest rate is that you will earn on your investment. Investments like this, where there
is absolute certainty regarding the return, are referred to as being “risk free”.

For the majority of investments, however, there is at least some degree of uncertainty as to
what the expected return is likely to be. The greater the uncertainty, the greater the risk
associated with that investment.

Uncertainty is a measure of how likely the realised return on your investment is to match
your expectations. The greater the possible range of returns you anticipate for an
investment, the less certainty you have as to the final outcome.

2.3.1 Measuring uncertainty

You are offered two investments, A and B. You anticipate that investment A could generate
a return of anything between 7% and 10%. Investment B, in contrast, is expected to
generate a return between 5% and 13%.

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We therefore have the following scenario for our investment returns:

Investment A: 7% 10%

Investment B: 5% 13%

It is clear from your expectations that investment B has the potential to generate a higher
return than investment A (13% versus 10%). However, if you look at the range of potential
returns for each investment, investment A has far more certainty than investment B as it has
a smaller range of possible outcomes. Therefore, it can be said that investment B has a
higher potential return than A, while A has a lower degree of risk than B.

Typically, the risk of an investment is measured using a statistic called the “standard
deviation”. Standard deviation is a measure of volatility of returns. The more dispersed the
returns on an investment are over time, the more volatile that investment is and the higher
its standard deviation will be.

Consider figure 1, which presents the cumulative returns over time for two investments, A
and B. The blue line represents the returns for investment A while the red line represents
investment B. The graph can be interpreted as the returns on a starting investment of R1 in
February 2003 until November 2009. Investment A clearly has significantly higher returns
over the period than investment B as R1 invested in A in 2003 grows to about R16 in 2009,
while R1 invested in B grows to a little less than R2 over the same period. Comparing the
shape of the two lines, though, note that the graph for investment B is much smoother than
that of investment A. Whereas investment B has steady growth over the period, investment
A has a number of big positive and negative spikes in its returns, creating a more jagged
graph. Investment A has a far greater volatility than investment B and would consequently
have a higher standard deviation, i.e. A is more risky than B.

Why does it matter how risky A is if it clearly and significantly outperforms B over the six
years? What if you only held your investment during 2008? If you held investment A, you
would have had a significant loss whereas if you held investment B you would have had a
small but steady gain. Risk is particularly important over short investment periods as you will
not have time to recover from a loss.

The complexities of the calculation of an investment’s standard deviation will not be delved
into here – it is sufficient to be aware that the standard deviation measures risk as a
percentage and that the higher the standard deviation of an investment, the greater its risk.

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18

16

14

12
Investment A
Investment B

10

0
August-04

August-07
August-03

August-05

August-06

August-08

August-09
May-03

May-04

May-05

May-06

May-07

May-08

May-09
November-03

November-04

November-05

November-06

November-07

November-08

November-09
February-03

February-04

February-05

February-06

February-07

February-08

Figure 1: Cumulative returns for two investments, A and B, over time. February-09

2.4 The relationship between risk and return

There is a trade-off between the potential return of an investment and its risk. The higher
the risk of an investment, the higher its expected return should be in order to compensate
you for the risk and vice versa. That is to say that no one would take on a high risk
investment unless there was some upside for doing so in the form of higher returns. Except
in very rare cases, this has always been an immutable law of investment. This is the reason
that unscrupulous investment advisors offering clients products that promise excessively
high returns with “no risk” should be treated with extreme caution!

If you consider fixed deposits to be risk free (given that they provide a fixed, and therefore
certain, rate of interest over a period of time) then any investment that has risk must offer a
return at least in excess of the interest offered on these deposits. This is referred to as the
premium earned for risk, or simply the risk premium. If they did not, what incentive would
investors have to invest in risky investments? Investors would all simply invest in fixed
deposits and earn equal or higher returns with no risk.

For example, consider two investment options. The first, a fixed deposit, offers you a fixed
interest rate of 5% for one year. The second, an investment in shares is expected to have a
return of 5% over the same period. Which investment would you choose?

Both investments offer the same return so the only question is what are their risks? The
fixed deposit has no risk as the interest rate is guaranteed for the year. The share

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investment on the other hand is likely to be risky as there is no certainty as to what its
return will be. Your choice is therefore easy – given two investments with the same return,
you would always pick the one with the lower risk; in this case, the fixed deposit.

What would you require to entice you to invest in the riskier shares? You would need to
have an expectation of a higher return to compensate you for the added risk.

When you evaluate the performance of investments, it is necessary to compare them not
only to other risky investments, but also to risk-free alternatives in the market. This is
typically done on a so-called “risk-adjusted” basis. This means that you exclude the risk-free
element from the returns on your investments so that only the reward for the risk taken on
remains. In this way, you isolate the portion of the performance of your investment that is
related to risk and are better able to compare one or more investments on the basis of their
risks relative to their returns. It must be stressed that investments should never be
compared on the basis of only return or only risk. The relationship between risk and return
means that any comparisons must reflect both aspects of investment performance.

2.4.1 Calculating and comparing risk-adjusted returns

Consider three investments, A, B and C. Investments A and B are risky and have expected
returns of 20% and 15%, respectively. Investment C, in contrast, is risk-free and has a return
of 5%. Investments A and B have standard deviations of 10% and 5%, respectively.

Which of investment A or B would you prefer, assuming that performance is the only
criterion influencing your decision?

Given that the risk-free rate of return on investment C is 5%, the risk premium for
investments A and B are 15% and 10% respectively. That means that 5% of A’s return is risk-
free and the remaining 15% comes from taking on the risk associated with A (as measured
by its standard deviation of 10%). Similarly, 10% of B’s return comes from taking on risk.
Therefore, investment A offers a higher return for bearing risk than investment B. As
indicated above, however, performance must be measured relative to both returns and risk.
The question, therefore, is whether the risk premiums for these investments are reasonable
relative to their risks.

If you compare the ratio of returns relative to risk for investments A and B, you will obtain a
more accurate picture of the real reward of each investment relative to the risk taken on.

The ratio for investment A is 15% ÷ 10% = 1.5 (it’s return relative to its standard deviation),
while that for B is 10% ÷ 5% = 2. This demonstrates that you are receiving 1.5% of return for
every 1% of risk taken on for investment A while you are receiving 2% of return for every 1%
of risk accepted for investment B.

Investment B is therefore the better performer on a risk-adjusted basis, even though the
absolute return for A is higher than that for B. The moral is that even though one asset
might have a higher return than another, when taking risk into account, it might not be as
attractive.

2.5 Investment portfolios and diversification

Thus far, the discussion has focused on individual investments. In practice, investors tend to
combine a number of investments together to form a portfolio. Such a portfolio may
comprise assets from a different number of classes of financial assets, such as shares, bonds,

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property, derivatives or cash. A broad portfolio allows not only for provision to be made to
meet investment objectives of different time horizons and goals, but also provides
diversification of investment risk. Diversification is personified by the old adage of not
placing all your eggs in one basket.

Consider again the scenario presented in section 2.4.1. Assume you wished to invest some of
your available funds in investment A and the remainder in investment B. What would be the
expected risk and return of your portfolio comprising the two assets?

The return of a portfolio of assets is simply a weighted average of the returns of each of the
assets constituting the portfolio. Unless the returns of all assets in the portfolio are the
same, the return of a portfolio will always be less than the highest asset return (20% in this
instance) but greater than the lowest asset return in the portfolio (15%). By diversifying
across a range of assets, you lose out on the returns you could have earned had you
invested solely in the best-performing asset in the portfolio, but you also avoid having
invested solely in the worst-performing asset in the portfolio. Keep in mind that you rarely
have prior knowledge of what the actual return on an investment will be and diversifying
allows you to mitigate the risk of overexposure to any single underperforming investment at
the cost of not maximising the benefit of well-performing investments.

The risk of a portfolio of assets operates slightly differently, due to the impact of
diversification. While many investors have an intuitive understanding of why it is important
to diversify one’s investments, many do not fully grasp the practical impact of diversification
on their investment portfolios.

Diversification refers to a reduction in the overall risk (standard deviation) associated with a
portfolio of assets as more investments are added to the portfolio. This reduction in risk is
brought about by the interaction between the risks of the different assets that constitute
the portfolio.

2.5.1 The principle of diversification

Consider the following example. You currently own shares in an ice cream retailer. When the
weather is sunny, the retailer’s sales are high but during winter, its sales volumes plunge. In
order to mitigate some of this risk during the winter months, you decide to invest in shares
in a blanket manufacturer. During the summer months the blanket manufacturer performs
poorly, but during winter its sales increase dramatically. In the context of your portfolio, the
poor winter months of the ice cream retailer are offset to at least some extent by the good
performance of the blanket manufacturer. During the summer months your ice cream
retailer offsets the poor performance of the blanket manufacturer. The returns for your
portfolio are therefore more consistent regardless of season and the overall risk of your
portfolio of investments is thus reduced.

The diversification in the example above is brought about by the fact that the risks faced by
the two companies are inherently different. In statistical terms, it can be said that the
correlation between the investments is low. Correlation is a measure of how closely two
things move together. As long as the returns of two or more assets do not move together
perfectly (i.e. a change in one is mirrored exactly by the same change in the other), they will
offset some of each other’s risk and result in diversification within the portfolio. The impact
of diversification is that the overall risk of the portfolio will always be less than a weighted
average of the risks of the individual assets within the portfolio and often less than the risk
of the least risky asset in the portfolio.

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As you add more uncorrelated assets to a portfolio you experience increasing diversification
and the overall risk of the portfolio continues to decrease. Diversification is an essential
means for managing the risk of an investment portfolio and results in a better relationship
between risk and return for your investments.

Diversification is based on how closely the risks of your assets are correlated. Assets within
the same sector and of the same class tend to have very similar risks. For example, mining
companies tend to face the same risks, but their risks differ from companies in the banking
sector. As such, a portfolio comprising only mining companies is going to derive little benefit
from diversification, but one comprising mining, banking and IT firms will allow for the
diversification of risks across the different sectors. Similarly, the risks of shares differ from
the risks of bonds, property and so on. It is therefore advisable to invest in financial assets
from different asset classes. A portfolio comprising shares, bonds and properties will benefit
more from diversification than one comprised solely of shares.

It is also important to be aware that there are limits to diversification. If it were possible to
diversify away more and more risk by simply taking on an increasing number of assets, it
would theoretically be possible to eliminate all risk and be left with a risk-free investment.
This is not necessarily the case in practice. Depending on the make-up of your portfolio, you
will eventually find that there is no further diversification possible and the overall portfolio
risk will plateau at a level that cannot be reduced by diversification alone. This is because
there are some factors, such as changes in the global economy, that affect all assets to some
extent, and whose effects cannot be removed by adding more assets to the portfolio.

At the same time, it is also important to note that the benefits of diversification become
incrementally smaller as you add additional assets to your portfolio. The first asset added
provides the biggest decrease in risk and the addition of further assets will result in
increasingly smaller reductions in portfolio risk.

There is also a cost to diversification. The purchase of each additional asset added to the
portfolio incurs transaction costs, meaning that it is important to balance the benefits of
diversification with the costs incurred in achieving diversification of your portfolio’s risk.

Given the marginal decrease in benefit of each additional asset, it is generally not
recommended to diversify across too many assets.

2.6 Determinants of investment suitability

The question of which investments will best meet your needs is a complex one that depends
on a number of factors. Before proceeding to examine these, however, it is important to
note two things. First and foremost, there is no “best time” to begin investing. Indeed, the
earlier you begin the process, the better. As demonstrated in module 2, investment value is
enhanced over time by compounding and the longer you allow your investments to work for
you, the better.

Secondly, there is no “one-size-fits-all” approach to investing. Your investment portfolio

should be a reflection of your unique characteristics and situation, and any decisions you
make in this regard or advice you receive should reflect this. The make up of each
individual’s investment portfolio should be different, depending on the financial assets most
appropriate for their needs. You are well within your rights to expect (and indeed should
insist) that any investment advisor should spend time becoming familiar with your personal
situation and needs before making any investment recommendations.

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2.6.1 The impact of the financial life cycle on investment objectives
Your investment needs are likely to be determined in large part by whichever phase of the
financial life cycle you are in, as detailed in module 1.

During the accumulation phase, the individual or household is still building up wealth, and
there is less focus on financial risk. The goal in this phase is to generate returns on
investments in the form of capital appreciation or the reinvestment of investment returns.
Such investments will tend to be riskier and of a long-term nature in order to maximise gains
to meet future obligations, for example shares.

The consolidation phase typically occurs as the individual enters the period immediately
after the significant financial obligations related to family life have been met (the children’s
educations, mortgage payments, etc.). During this phase, capital accumulation may still
occur but there is an increasing focus on capital preservation in order to protect wealth
against loss and to prepare for retirement. The goal in capital preservation is to protect your
wealth against loss or depreciation of value and there is a shift towards lower-risk
investments of medium-term duration, such as bonds.

During the final phase of the financial life cycle, there is a cessation of work-related income
and new wealth is generated only through the appreciation in value or income generation of
existing assets. The goal during this phase of the life cycle is both capital protection and a
desire for current income to meet the investor’s needs. Investments suited to this objective
are typically interest-bearing instruments that yield a consistent, regular income return over
time but can also include more risky investments such as blue-chip shares that have a
history of paying consistent dividends. In both instances, the capital portion of the
investment is left untouched while the income portion is used to meet the investor’s day-to-
day needs.

2.6.2 Investment considerations and pitfalls

The process of investment planning is fraught with difficult decisions and potential pitfalls.
At the outset, it is essential to frame your investment objectives within the context of the
stage of the financial life cycle you are in, as detailed above. It is then important to establish
the risks and obligations you presently face, which may constrain your capacity to invest,
such as limited or inconsistent income streams. Lastly, you should establish your risk
tolerance, as this will further clarify which financial assets are suited to your risk profile.
Within the context of these three steps, it is important to be mindful of the following issues.

Be realistic about your goals and needs

While everyone aspires to a higher quality of life, it is important to be mindful of the realities
of your situation and what is practically achievable. Where your investment objective is the
accumulation of wealth, always bear in mind the cardinal rule of investing: higher returns
are only possible by taking on higher risks. Be realistic about your income and your needs
and, to the best of your ability, match your investments to meeting these requirements.
Remember that investment planning is not a static activity and you will need to revise these
goals as they are met, so aim to start small and build steadily rather than overreaching at
the outset.

Maintain cash reserves

It is advisable to provide for cash reserves in addition to any other investments you might
have. Such reserves are quickly accessible in emergencies and ensure that you do not need
to dip into your other investments to cover any unexpected short-term obligations that may

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arise (this is especially important as many investments penalise you for early withdrawal of
your capital). The size of the appropriate cash reserve varies from individual to individual but
it is generally accepted that anything between three and six months’ salary should provide a
reasonable cushion in case of emergencies.

Avoid mental accounting

People have a tendency to compartmentalise the world around them to make it easier to
understand and treat their investments no differently. Most people will consider their
investment objectives in isolation. For example, an investor faced by the looming prospect
of their child one day attending university, while simultaneously wishing to prepare for a
comfortable retirement, may consider the two objectives as distinct and therefore evaluate
them in isolation. This is called “mental accounting”. Practically, however, it is better to view
all investments as part of a single overall portfolio. Remember that diversification has
implications for the overall risk and return for your investment portfolio across all of your
investments.

Re-evaluate and rebalance

Your needs and situation change over time and your investment portfolio should be no
different. It is essential to re-evaluate your investment objectives and portfolio at least
annually in order to determine which, if any, of your goals should be updated and whether
this means that your investment portfolio needs to be rebalanced. The process of re-
evaluating and rebalancing is natural given the change in each individual’s financial life cycle
over time, but it is one often overlooked by investors.

Be mindful of your investment horizon

It is important to determine accurately the horizons for your investment objectives to
ensure that you are able to meet your obligations as they fall due. This is particularly
important in the context of longer life expectancies that have extended the retirement
period for many individuals. What was considered an appropriate provision for retirement
10 years ago is likely to fall woefully short today. Many retirees have been caught with
insufficient funds to see them comfortably through the duration of their retirements.

Avoid speculation and market timing

Many investors (both novices and professionals) are driven by a desire to “beat the market”,
no doubt motivated by media reports of maverick traders who ignored conventional wisdom
and came good. Speculation is the participation in an investment of substantial risk with a
view to earning significant returns. It is the excessive riskiness of speculation that separates
it from ordinary investment and speculators often make their investment decisions on the
basis of very narrow perceived opportunities. Market timing, in contrast, is an attempt to
invest on the basis of phases or trends in the general market. For example, recent news
reports might indicate that the economy is showing signs of growth and expansion and you
might believe that there will be a positive upturn in the market in the near future as a result.
In order to take advantage of this perceived opportunity you increase your holdings in
shares.

Neither speculation nor market timing is necessarily a negative activity. Both have their
place in the investment community but their inherently short-term focus is often contrary to
the process of personal investment planning. The purpose of personal investment planning
is to align the individual’s typically longer-term goals with the appropriate investments.

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Consider the impact of inflation
It is easy to fall into the trap of evaluating the performance of your investments purely on
the basis of their comparative risks and returns without considering the impact that inflation
has on your returns. Inflation is of particular importance when planning for retirement as it
erodes the real value of your investments over time and may result in your provision for
your golden years being significantly less than expected.

Be mindful of the relationship between age and risk tolerance

All individuals go through various stages in their own personal financial life cycle, many of
which are dependent on age. While not absolute, there is typically a relationship between
an investor’s age and degree of risk tolerance.

As mentioned in module 1, younger individuals tend to have a higher appetite for risk and
are willing to take on riskier investments with commensurately higher returns. Younger
individuals are better able to cope with the potential losses on such high-risk investments as
they have more time to recover. Older individuals, in contrast, tend to be more risk averse,
as they cannot easily recover from significant losses on their investments. This is particularly
true where retirement is looming and the protection of wealth is far more important than
the accumulation thereof.

As a general rule, it is expected that younger investors will favour higher-risk, higher-return
investments while older individuals will increasingly prefer lower-risk investments with more
consistent (albeit lower) returns.

Know your investment liquidity

The liquidity of an investment is a measure of the ease with which it can be converted to
cash without a significant loss of value. The latter part of the definition is perhaps the most
important characteristic of a liquid investment. Just about anything can be converted to cash
if the price is right – that in itself does not denote liquidity. Rather, liquidity pertains to the
ability to do so at short notice without having to accept a significant decrease in value.

The liquidity of an investment is a key determinant in investment selection as it provides a

measure of flexibility to your portfolio and allows you to react with minimal cost to
unexpected events or changes to your needs. Assume, for example, that you have a
significant sum to invest and you have a choice between investing in property or in a
portfolio of shares. You elect to invest in the property and 10 years later you’ve seen a
significant return on your investment. However, disaster strikes and you suddenly find
yourself in urgent need of funds. Given that property is typically less liquid than most other
investments, the process of selling your property and gaining access to the cash you
invested is likely to be time-consuming and costly. Had you invested in the portfolio of
shares instead, you would have had an easier time converting your investment to cash.

Therefore, when making investment decisions, it is essential to ask yourself how likely you
are to require access to that capital at short notice in the future.

Avoid the “fear-greed” cycle

Investors, being emotional beings, are driven by sentiment. When the market experiences a
decline, many investors make the decision to disinvest while the reverse is true where the
market enters an upturn.

Unfortunately, investors, being conservative for the most part, tend to delay this decision
until well after the impact of the market change has been absorbed into the value of their

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investments. They therefore sell their investments at the bottom of the downtrend and
realise a significant loss or invest heavily after the upward trend in the market has already
peaked and pay more for their investments.

The result is that, contrary to the prevailing sentiment of “buying low and selling high”,
investors buy high and sell low. In most instances, it is far more beneficial to take a long-
term view with your investments and ride out any short-term market corrections.

3. Financial markets
Financial markets are environments that allow investors to buy and sell financial assets.
While the types of financial markets vary greatly, they share the common trait that they
match buyers and sellers of specific financial assets.

 Capital markets facilitate the trade of long-term securities such as shares and bonds.
They comprise both institutional investors (such as investment banks and asset
managers) and private individuals. The Johannesburg Stock Exchange (JSE) is an
example of such a market.

 Money markets involve the buying and selling of short-term debt securities and are
typically driven by banks and other large institutions.

 Derivatives markets facilitate the trade of derivative securities, which are typically
used in risk management but may also be used for speculation.

 Other common markets include commodities and foreign exchange markets.

The majority of investment planning for the individual occurs within the capital and money
markets, while institutional investors are typically active within all four markets. Our focus
will therefore be restricted to the capital and money markets.

3.1 The capital market

3.1.1 Shares
When companies raise capital, they do so by issuing shares (also referred to as equities or
stocks). These shares are a form of financial security that represents ownership in the
company. For example, if you held 10% of the ordinary shares (Class A) in a company you
would have a claim against 10% of the assets of the company. Although both private and
public companies issue equity, it is only the shares of public companies that are freely
traded in the marketplace. Ordinary shares provide shareholders with voting rights, granting
them a say in the running of the company. In addition, the shares allow shareholders to
participate in any distributions of the company’s profits when the company declares
dividends.

Companies may issue many more esoteric forms of shares, each with specific rights and
restrictions to shareholders, but fundamentally, the majority of shares traded in the market
are ordinary shares as defined above.

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The returns on share investments

As illustrated in Section 2.1.1, the returns on share investments derive in part from the
increase in the share’s price over time (capital appreciation) and partly from any dividends
distributed by the company to its shareholders.

The price of a share fluctuates over time depending on a range of factors, from the supply
and demand of the share to the impact of economic and political events. Generally, the
higher the demand for a share and the more positive the expectations regarding its future
performance, the greater its price, and vice versa.

Dividends are a distribution made by a company to its shareholders out of the profits it has
earned. Companies are under no obligation to pay dividends and the timing and frequency
of dividend payments varies from company to company. The decision that every company
faces is whether to retain its profits for use in its future operations, typically to expand its
operations and assist in growing the business, or whether to distribute a portion of its profits
back to the shareholders. Generally, smaller companies that are still in the early phases of
growth prefer to retain their profits to help finance their continued expansion. Larger,
established companies tend to reach a point where they have economies of scale and find
that they have limited opportunities to utilise their profits productively. Such businesses are
more likely to distribute their profits to shareholders.

The fact that dividends are not guaranteed is important when considering shares as a form
of investment for deriving a consistent income to supplement your day-to-day financial
requirements. Some companies have never paid dividends and have no plans to do so. For
example, Microsoft was founded in 1975 but paid its first dividend only in 2003. The returns
on such investments derive solely from the capital appreciation in the share price. Other
companies pay consistent dividends and are a reliable source of current income.

A company’s historical dividend policy is typically a good indication of future expectations

regarding dividend payments. Shareholders prefer consistency in the distribution policies of
companies and research has indicated that South African investors have penalised
companies harshly when they have reduced or even cut their dividend payouts
unexpectedly. Thus, company directors and managers have a vested interest in maintaining
their dividend policies as far as possible.

3.1.2 Bonds
Bonds are debt securities, typically issued by public companies or public authorities (such as
government or municipalities), in order to raise financing. They share characteristics with
loans, with the fundamental difference being that bonds are traded in the financial market.

The issuer of the bond will raise the funding it requires by selling the bond to a buyer (the
bond holder) at an agreed market price. In exchange, the bond issuer will pay the bond
holder a fixed rate of interest known as a coupon, with payments made either annually or,
more commonly, semi-annually. These payments will be made over the life of the bond,
referred to as the “maturity period” of the bond. At the end of the bond’s maturity, the
issuer of the bond will repurchase the bond from the bondholder at a price referred to as
the bond’s “face value” (also sometimes called the par or nominal value of the bond). Bonds
are bought and sold on a daily basis at market-determined rates, which may or may not be
equivalent to the par value of the bond.

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Consider an example: Company A finds itself in need of urgent funding in order to finance an
expansion of its operations. It decides to issue bonds rather than obtaining a loan. The
bonds are issued in 2008 with a face value of R10,000 each. The bonds pay a coupon of 5%
on the par value of the bond, semi-annually in June and December (this is typically quoted as
10% with the expectation that the investor will be aware that this is paid in two equal
instalments every six months). The company expects its expanded operations to repay their
cost in about 10 years, so the bond is set to mature in 2018.

If you were an investor who was interested in purchasing these bonds, you could buy them
like any other financial asset in the market. The price you would pay could be R10,000 (the
par value) or it could be higher or lower than this, depending on market conditions. As a
holder of these bonds, you would be entitled to a coupon payment of R500 every six
months, in June and December. In 2018, when the bond matures, if you still owned it,
company A would repurchase the bond from you at a price of R10,000.

Given that the coupon payments on a bond are regular and consistent, they are an ideal
form of investment for those desiring current income.

Bonds differ from shares in that shares represent ownership in a company, with all the
corresponding benefits and obligations thereof, while bonds simply constitute a loan
agreement between the issuer and holder.

The return on bond investments

Bond prices change on a daily basis in the same way as other financial securities. The return
on a bond is determined in part by any capital appreciation on the bond as its price
increases over time (the capital gain) as well as the coupon payments made on the bond
(the income component). The return on a bond at any given time is referred to as its “yield
to maturity”, or simply its “yield”. The yield to maturity represents the annual return you
would earn on a bond if you bought it at that date and held it until maturity. For example, if
you picked up your financial newspaper today and found that the yield on the R157 bond
was 8%, that would mean that you could expect a return of 8% per year if you held the bond
until maturity.

It is useful to know that bond yields are determined in large part by interest rates in the
market. This makes sense when you consider that bonds are essentially loans. As interest
rates increase, bond yields increase and the prices of bonds decrease. Conversely, as
interest rates decrease, bond yields decrease and the prices of bonds increase. This is
related to the time value of money. You may recall that the discount factor for a cash flow
determines the present value of that cash flow. The higher the rate of return on an
investment, the higher the discount factor and the smaller the present value and vice versa.
Therefore, when bond yields decrease, the bond’s cash flows are being discounted at a
smaller rate and the present value of the bond (i.e. its price) is higher. Similarly, when bond
yields increase, the bond’s cash flows are being discounted at a higher rate and the present
value of the bond is lower.

Given this relationship between bond yields and interest rates, it is said that bonds are
susceptible to interest rate risk. As interest rates change, so do bond prices. Where they
move favourably and decrease, bond prices increase and bondholders gain on their
investments, but when they increase, bond prices decrease and bondholders lose on their
investments.

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Bonds are also susceptible to a second form of risk, namely credit risk. It has been
mentioned that bonds are similar in many respects to loan agreements and like loans, bonds
are open to the possibility of default. Default or credit risk refers to the possibility that the
bond issuer may be unable or unwilling to meet their obligation to purchase the bond back
at the end of its maturity. In such an instance, it is possible to lose the value of your
investment. Government bonds are far less prone to default risk than bonds issued by
companies.

3.1.3 How are capital market investments traded?

The shares of public South African companies are traded on the Johannesburg Stock
Exchange (JSE). The JSE provides for two divisions on which companies are listed – the main
board caters for larger, established companies that are more liquid. The Alternative
Exchange (AltX) is intended for smaller, new companies, but due to their limited track record
these shares tend to be less liquid than their bigger, more established counterparts.

In addition to listing shares for trade, the JSE also makes data on share indices available. An
index tracks the performance of a basket of shares or other assets. Indices are constructed
both for the overall market and for individual sectors of the market, and provide investors
with a quick way to gauge the performance of the underlying assets in the index. For
example, the All Share Index (ALSI) comprises the top 99% of the shares listed on the JSE by
size and liquidity. The financial news presented in the evenings will mention whether the
ALSI has gone up or down a certain number of points. When the index has gone down,
because the ALSI comprises the majority of shares on the exchange, the move is interpreted
as the market, as a whole, having had a negative return for the day (note that in actuality,
some shares may have had positive returns while others will have had negative returns – on
aggregate, however, the value of the market will have decreased). The reverse is true when
the ALSI has gone up.

As mentioned, indices are not only used to track share performance. Like the ALSI, the All
Bond Index (ALBI) tracks the performance of a wide range of bonds traded in the South
African bond market.

Only registered brokers are allowed to trade on the JSE. In order to buy or sell shares on the
JSE, you need to open a brokerage account with a stockbroker registered on the exchange.
The stockbroker will then carry out any trades you require on your behalf, for a fee. Many
stockbrokers deal exclusively with institutional clients only, but a number specialise in
individual clients and the JSE maintains a list of these stockbrokers on its website.

Stockbrokers provide various services to assist you in managing your investments. These
include discretionary services, where the stockbroker is empowered to make investment
decisions on your behalf without requiring confirmation, but with pre-defined objectives in
mind. Alternatively, the stockbroker may provide non-discretionary services, where you are
provided with advice but ultimately all investment decisions are made by you. The fees
charged for these services vary according to stockbroker but can be substantial.

Until a few years ago, bonds were traded on the Bond Exchange of South Africa (BESA). The
BESA was purchased by the JSE in 2009, however, and now bonds are also traded on the JSE
and require the assistance of a broker.

Recently, online brokerage platforms have made it possible to invest on the JSE without the
need to open a brokerage account. Such platforms are provided by all of the major banks
and these providers are mandated by law to provide their clients with access to investor

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training. Like traditional stockbrokers, these platforms charge a range of fees for their
services, but may be more cost effective for smaller investors.

3.1.4 The costs of investing

There are a number of costs involved with transacting with your broker. The impact of these
fees is felt most strongly when small amounts are invested, as some fees are fixed regardless
of the size the transaction, so it is essential to determine whether the perceived benefits of
your investment outweigh the associated costs. This is also an added incentive to construct
your investment portfolio with a long-term view. You incur transaction costs both when you
buy assets and again when you sell them. Changing your portfolio on a regular basis will
therefore incur significant transaction costs, which will quickly erode the returns you earn
over time. It is far more beneficial to buy financial assets with a view to holding them for
long periods of time.

As an example, consider the fees which are applicable when shares are being bought or sold:

 Brokerage fee: Brokers are allowed to fix their own brokerage fees for purchases
and sales of investments. These typically range from 1% to 1.5% of the amount
invested. In addition, there is typically a minimum fee in place and some brokers
charge a flat fee rather than a percentage rate.

 Securities Transfer Tax (STT): A tax charged by SARS at 0.25% of the invested
amount when shares are purchased.

 Investor Protection Levy (IPL): The investor protection levy is charged by the FSB at
0.0002% of the invested amount for both purchases and sales of shares.

 Strate fee: A fee of 0.005459% of the purchase amount is levied for the transfer of
funds from the buyer’s account to the seller’s account via the electronic settlement
system used by the exchange (Strate). This fee is charged on both purchases and
sales.

 VAT: SARS charges VAT of 14% on both purchases and sales of shares.

 Capital gains tax: SARS charges a capital gains tax on the profit arising from any
investments sold by an investor.

3.1.5 Active versus passive investments

Investing in individual shares can be a costly exercise and many investors do not have the
technical acumen necessary to identify the best shares to match their investment
requirements. It is also important to be aware of the fact that the JSE restricts purchases of
shares to lots of 100. Given the high prices of shares listed on the JSE, this effectively places
many share investments out of reach of the ordinary investor.

It is unsurprising, then, that many investors prefer to entrust the management of their
investment portfolios to “active fund managers”. The role of an active fund manager is to
make investment decisions on your behalf and then charge a fee for their expertise. The
most common example of this is in the form of unit trusts. Unit trusts are created when the
management company pools funds from numerous investors in order to invest in shares
listed on the JSE. The unit trust is then divided into units, which are allocated to
shareholders on the basis of the amount they invested. The pooled nature of the investment
means that shareholders are able to gain access to investments in expensive blue-chip

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stocks, even though they may not have sufficient funds to make such an investment on their
own. In addition, because the fund invests the money in a broad range of assets, you gain
access to a diversified investment, even though you are investing in only a single product.

While the benefits of unit trusts are significant, there are two considerations to be mindful
of. Firstly, as they are actively managed, they attract significant management and
administrative fees. Secondly, unit trusts and other forms of active management pre-
suppose that fund managers have a set of skills that allows them to outperform the market
and generate superior returns to what the average investor would have been able to
achieve. Research has indicated that this is not always the case and that, while the majority
of fund managers may have periods where they outperform the market, on average they
tend to underperform the market over time, particularly after taking into account the fees
levied.

Consider figure 2, which illustrates the impact of active management fees on a hypothetical
lump sum investment of R100,000 invested in shares. For investment A, you selected the
shares in your portfolio and made your purchases through a broker. For investment B, you
made an equivalent investment into an actively managed unit trust and attracted active
management fees. Assume further that both investments earn the same return of 15%. It is
clear from the graph that the management fees of the unit trust reduce the returns of
investment B substantially, when compared to that of investment A.

Figure 2: The impact of management fees on investment returns.

Source: JSE Magazine, August 2009

An alternative form of investing, referred to as “passive investing”, has become increasingly

prominent in recent years. Rather than attempting to identify individual shares that will
outperform the rest of the market, a passive investment is one that tracks the market in an
attempt to replicate the overall performance of the market. Passive investing does not use

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active management skills and typically has significantly lower fees than those charged for
active investments.

The primary vehicle for passive investment is exchange-traded funds (ETFs). ETFs are
products that are listed on the JSE and track the performance of a basket of shares, bonds or
commodities. As they are listed, they can be bought and sold in the same way as any other
shares. Like unit trusts, they represent a diversified portfolio of assets with the purchase of a
single investment. In addition, the fees on ETFs are significantly lower than those of actively
managed funds. The number of ETFs in South Africa is limited but growing as their popularity
increases. The majority of ETFs track the performance of specific indices, such as the Satrix
40, which tracks the performance of the 40 largest shares listed on the JSE.

3.1.6 Interpreting information in the financial press

Share price information is provided daily in the financial sections of all major newspapers.
Such information is always provided after the fact, such that the information will cover the
previous day’s trades (or the previous Friday’s trades, in the case of a Monday paper).
Provided below is a brief explanation of the various terms and concepts employed. Note
that all prices in the financial press are typically quoted in cents.

 Close: The final trading price of the share in the previous day’s trade.

 High: The highest price at which the share traded over the previous day.

 Low: The lowest price at which the share traded over the previous day.

 Daily move (DM): The change in price for the share over the previous day.

 Dividend yield (DY): The ratio between the dividends paid in the current year and
the last close price for the share. It represents the percentage dividend return of the
share. (Dividend per share divided by the current market price per share)

 Price earnings ratio (PE): The ratio of the share’s last close price to its current
earnings. This provides a measure of the company’s expected relative performance
to its current performance. (Current market price of share divided by earning per
share)

 Daily volume (DV): The number of shares traded in the previous day. The higher the
number, the more liquid the share.

3.2 The money market

The money market facilitates the trade of assets involving short-term, interest-bearing
borrowing and lending, usually for periods of no more than a year. These investments best
match the objectives of clients with short investment horizons.

Detailed briefly below are the most significant investment instruments traded in the money
market.

3.2.1 Fixed deposits

A fixed deposit is a form of investment where a sum of money is placed in a deposit with a
financial institution and cannot be accessed for a pre-specified period of time as determined

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by the terms of the arrangement. For example, you may be offered a 12-month fixed deposit
at a rate of 10%. You will not have access to the funds in the account until the end of the 12-
month period and your rate of interest over the period will be fixed at 10%.

The lack of access to the funds within a fixed deposit limits your flexibility, as the funds
you’ve deposited cannot be tapped in emergencies. The interest rate on such accounts
tends to be higher for other more flexible money market accounts, however, to compensate
for this lack of liquidity.

Similarly, the fixed interest rate can be both a benefit and a disadvantage. Where the
Reserve Bank lowers interest rates in the market during your investment period, the rate
you earn on your interest-bearing investments will also tend to decrease. With a fixed
deposit, however, you have locked in your rate and are not susceptible to such downward
movements. However, where the interest rates in the market are increased, you also lose
out on the corresponding increase in interest rates on your other interest-bearing
investments.

3.2.2 Money market accounts

A money market account is a form of deposit account offered by banks that typically pays
higher interest rates but also requires higher minimum deposits. The interest rates offered
on such accounts are typically linked to the sum deposited, such that higher deposits attract
higher rates of interest.

Unlike fixed deposits, the funds deposited within a money market account are available on
demand but the large minimum deposits required are a barrier to investment for many
smaller investors.

3.3. Capital market history

It has already been established that investments have different risks and rates of return, and
that it is essential to match any investments you add to your portfolio with your risk
preferences and other investment criteria.

1000000

100000

10000

1000

100

10

0.1
1989 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009

Ordinary Shares Long-term Government Bonds Money Market Index CPI

Figure 3: The growth in R1 invested in three different asset classes: 1900 – 2010.

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Figure 3 illustrates graphically the actual growth in R1 invested in portfolios of ordinary
shares, bonds and money market investments from the period 1900 to 2010. The data was
obtained from a research paper by Firer and Staunton (2002) and updated to include the
most recent market data for these three asset classes. The share portfolio represented a
large diversified portfolio of shares trading on the JSE, the bond portfolio comprised a
portfolio of long-term government bonds, while the money market portfolio was made up of
a portfolio of 90-day money market instruments.

Examining figure 3, it is evident that the share portfolio outperformed the other two asset
classes by a significant margin over the 110-year period examined. It is clear that shares
provide significantly higher returns than other asset classes over long investment horizons. It
can also be seen that the return on the cash portfolio was only marginally higher than the
inflation rate (CPI) over the period, indicating that cash investments do not provide much of
a return above inflation. Table 1 below presents a summary of the average annual returns
and standard deviations for each of the asset classes as a means for comparison.

Asset Average annual return Annual standard deviation

Shares 14.8% 22.7%

Bonds 7.2% 9.4%

Cash 6.1% 5.6%

Inflation 5%

Table 1: Average annual risk and return for each of the asset classes considered.

This confirms the earlier discussion of the relationship between risk and return. As share
investments yield higher returns than bond and money market investments, they would be
expected to have higher risks, as confirmed in the analysis in table 1. Bonds in contrast have
lower returns than shares and a commensurately lower risk, while money market
investments have the lowest returns of the three asset classes but also the lowest risk.

The return on share investments will dominate those on bond and money market
investments over long time horizons. Where investors have a long investment period, it is
advisable to consider share investments. Even though the graph demonstrates significantly
more fluctuations in share returns, these fluctuations are smoothed out over time and the
general trend in long-term share returns is always upward. Over shorter periods, however,
market fluctuations mean that it is entirely possible that you will suffer significant losses on
your share investments. It is therefore advisable for shorter periods to consider bond and
money market investments to meet your investment needs.

The long term is defined as any investment period in excess of 10 years, the medium term as
a period shorter than 10 years but in excess of one year, and the short term as any period of
one year or less. As a general rule of thumb, share investments tend to be preferable in the
long term, bond investments in the medium term and money market investments in the
short term.

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4. Summary
This module has provided an introduction to many of the concepts fundamental to
understanding the investment environment. While the complexity of the discussion has
been limited due to the scope of the course, it is advisable to continue reading and
broadening your knowledge of the concepts raised here.

In this module, you:

 Examined the relationship between risk and return and determined that higher
returns are typically associated with higher risks.

 Learned about diversification and the benefits of spreading your investment across
multiple assets of the same type and across different types of assets.

 Explored the factors that impact on the decision of which investments best suit your
needs and objectives and learned that it is necessary to match the timing of your
financial obligations with the holding period of your investments.

 Learned about financial markets and the primary investment instruments (shares,
bonds and money market instruments) that trade within them.

 Examined the difference in returns between shares, bonds and money market
investments in South Africa over the past 110 years.

5. References
Firer, C and Staunton, M., 2002. 102 Years of South African financial market history.
Investment Analysts Journal, 56, 57-65.

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