One of my readers has asked me to do a blog post on portfolio construction for the South African retail investor. When I received that request (by both mail and twitter), my draft email response opened with ‘Unfortunately, this isn’t really blog post material, because it has to be so specific to the individual.’ But then I changed my mind.
Mainly because I started thinking about my personal ‘portfolio construction’ – which strays quite far from the traditional investing rules.
First, Some Disclaimers
This isn’t financial advice. Unfortunately, that’s become quite regulated – and I’d need to open a file for you, and do some KYCing, and consider your risk profile, blah blah blah. Rather, consider these as being more like some general guidelines and observations for you to chat about with your real financial advisor. You know, the one that’s already done the regulatory legwork.
Portfolio Construction: what is this ‘portfolio’ anyway?
So if I’m honest, I don’t like the word ‘portfolio’. It makes the whole thing sound far too technical before you’ve even started. Instead, think of it as your ‘savings’. And these savings can happen all over the place:
- Your pension/retirement/provident fund contributions
- Any money in the bank and/or fixed deposits
- Your downpayment and mortgage-repayments on your house
- Monthly debit orders to Allan Gray or Sanlam
Really, it’s all the money that you’re not spending on daily living. That is: it’s the money that you’re setting aside to cover you in the future.
In fact, I would even say that your insurance policies are part of your savings. Insurance may feel like an expense – but for policies like income protection, homeowner insurance and so on, you buy them to cover you in the future. The only difference is that those are ‘savings’ that you can never touch unless the bad thing that you’re insuring against happens. Which is exactly what you want, if you think about it.
And if that’s the case, your first bite at the portfolio construction apple has plenty of low-hanging fruit:
- Make sure you have good insurance policies in place;
- Take advantage of the tax benefits of some kind of pension plan;
- Keep some emergency money in reserve; and
- Earn the guaranteed returns on paying down your debt.
The Guaranteed Returns of Debt
This is something that people often don’t think about: every time you prepay debt, you are ‘investing’ that money and earning saved interest.
Consider these two:
- John has a R100,000 overdraft, incurring interest at 20% per annum. He also has R60,000 of savings in a balanced fund, earning 10% per annum.
- Mark was in the same position, but cashed in his balanced fund and used it to pay down his overdraft. He now has a R40,000 overdraft, still incurring interest at 20% per annum.
Who is better off?
- John has savings income of R6,000 and an interest expense of R20,000. He’s out of pocket by R14,000 at the end of the year.
- Mark has an interest expense of R8,000, so he’s only out of pocket by R8,000.
Why? Because Mark used his R60,000 to earn a guaranteed return of 20% in interest savings*.
*R20,000 of interest expense on the original R100,000 overdraft, less the R12,000 ‘earned’ in interest savings by the R60,000, gives you the R8,000 out-of-pocket at the end of the year.
I’ve used the example of an overdraft – but the most common source of ‘guaranteed returns’ is mortgage (or home loan) prepayments.
And to reiterate, for most people, this is where the best returns are to be found. It’s also where there is a ‘comparative advantage’ for the middle class. The wealthy have too much money to allocate to these small pockets of extra return. If you’re worth billions, you probably already own your home. And if you’re looking to invest in property, you can’t be bothered with individual apartments or small homes – you’re chasing after shopping centres and massive office blocks for your ‘interest’ savings.
But after that, it’s time to play
So once you’re done hoovering up all the low-hanging fruit, you can now decide what to do with the extra savings. If you’re fortunate enough to have them. And this is where most people start talking about on-shore and off-shore investments. And about stocks and bonds and exchange traded funds.
Here are a few things to bear in mind:
- If you live in South Africa, most of your future spending will be in Rands. So it’s okay to invest in South African assets (not everything has to be ‘offshore’ all the time).
- Because most of your ‘portfolio’ (especially when you’re starting out) is going to be bound up in ‘investments’ that are meant to cover you in emergencies, you can take some risks here.
The Traditional Portfolio Allocation Rules
Here are the old school financial planning heuristics:
- The younger you are, the more risk you should take on;
- Equities and most commodities are very risky, bonds and property are quite risky, government t-bills and cash are extremely safe.
- Emerging markets are high risk, developed economies are low risk.
- Derivatives are not for retail investors: they’re for gamblers.
- Alternative asset classes (art, wine, whisky and cars) and private equity are for the wealthy.
Putting that together:
- if you’re young, you should put your money into the stock market.
- if you’re middle-aged, you should put your money into a balanced fund (preferably one that invests both on-shore and off-shore) and investment property; and
- if you’re old, you should put your money into safe government bonds and offshore bank accounts.
Portfolio Construction: An Alternative Suggestion
I’ll be frank: I’ve ignored many of those traditional rules when it comes to my own savings. While I’m all about the low-hanging fruit, I’m less interested in the traditional portfolio allocations.
Before I get to what I am interested in, here are some background principles that I’ve adopted:
- While I’m young, and while I’m in the ‘asset acquisition’ stage of my earnings-wealth life cycle, I want to take on risk.
- This is the time to do it: while my cost base is still quite low (ie. no school-going children or adult dependents), and while I still am covered for my day-to-day living expenses by my salary.
- Generally speaking, that means that my capacity to absorb investment losses is (quite possibly) at its peak.
- I also want to take risk where I can find some kind of a ‘comparative advantage’.
Bearing that last point in mind, here is my issue with traditional asset classes:
- They are heavily-traded by people who have devoted their entire lives to that particular asset class. Or, worse, to a particular asset in that particular asset class.
- I can’t really hope to out-do them. In fact, it’s way more likely that I would end up being the mug on the wrong side of the trade.
- So my only real option here is to put money into a low-cost index fund that tracks the entire asset class, in the cheapest way possible.
And I definitely do that last one. My monthly debit orders go into the Satrix Top 40. It’s equity (risky) with some offshore exposure (because many of those shares are Rand-hedges). And apart from that, I pay no attention to it.
In truth, that was a once-off decision that I made more for convenience’ sake. I was trying to set up a state of inertia whereby my own laziness would help me accumulate capital. (If you’re interested in how I turned my sloth into savings, check out this post: Be Lazy About Saving Money).
Then there’s the Tax Free Savings Account.
But as for the rest – there, I am all about the alternative asset classes.
Alternative Assets: Why I Am A Fan
Alternative assets are one of the few places where you can (relatively) easily have an edge. When big institutional wealth and asset managers have to allocate the funds that they have under management, they need to do it efficiently. So they look for investments with market depth (like the stock markets, commodity markets, bond markets, etc), where they can deploy vast amounts of capital quickly. Here is what they don’t buy:
- R2,000 bottles of special edition whiskey;
- R100,000 pieces of contemporary art from reasonably well-established artists;
- Rare books from the auctions of deceased estates;
- Anything that can’t be bought in bulk off an exchange.
Even the wealthy tend to avoid this level of investing. Consider this:
- Let’s say that I buy a R2,000 bottle of whiskey, and in five year’s time, it’s worth R10,000.
- For me, that’s a fantastic return. 38% per year! Hell yes I’d buy and store that bottle. I’d even insure it!
- For a wealthy person though, that’s only R8,000: which is the cost of a semi-decent night out, with wine.
- It’s not worth bothering with.
And it’s why there’s a comparative advantage:
- For me, taking time out to research, buy and store a whiskey bottle is definitely worth the potential return.
- For the big asset managers and the especially wealthy, it’s a waste of time.
Yes, alternative assets can be high risk.
But becoming a collector has its own return on your time investment. You get to know the market, which means that you’re more aware of the deals that come up. You also learn when and how to sell. All of that lowers your risk of bad investments. And collecting has the benefit of being gratifying.
I realise that it’s anecdotal, but many of my more eccentric friends are collectors. They collect things like modern art, whiskey, stamps, special edition Barbie dolls and collectible cars (generally, the car collectors have to do it as a group). And when you see someone sell off a single doll to pay for a full year’s worth of school fees, you’d best believe that I’m impressed.
For other posts where I’ve explained my soft spot for alternative assets in more detail:
Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, or like the Rolling Alpha page on Facebook at www.facebook.com/rollingalpha.