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Tutorial 7 - Portfolio management

Tutorial 7 - Portfolio management

Executive Summary

After completing this tutorial, the investor will understand what is meant by term, return and risk means. Furthermore, an investor will learn how to use important risk management strategies such as a stop-loss strategy, diversification and how to structure a portfolio correctly. Finally, we discuss how Rand-cost averaging works.

Introduction to Portfolio Management

In addition to the question of what to buy and sell and when; which are essentially analytical methods, there are several approaches to the share-market which focus on strategy rather than analysis. These approaches are not alternatives to fundamental and technical analysis, but portfolio management strategies which can and should be used in conjunction with the analytical methods.

We cannot over emphasise the importance of these strategies. Investing is far from an exact science. You can do all the fundamental and technical analysis you like, but you are still going to make a few disastrous investments. It is therefore of utmost importance that you safeguard yourself from total financial ruin. This safeguard can only be achieved by ensuring that effective overall portfolio management strategies are in place.

To get the maximum benefit from one's share portfolio, planning is important. This ensures that the share portfolio is not undertaken in a haphazard fashion but in such a way that they fit in with one's financial needs and available resources. With proper share portfolio planning, an investor increases his chance of success on the share market. Despite the general principles of portfolio planning that will be discussed in this lesson, it is good to remember that there are really no hard and fast rules. Ultimately, one's choice of shares is a personal matter, depending on taste, temperament and one's own assessment of the company involved. Nevertheless, we believe that a planned portfolio has a far better chance of success than a list of randomly selected shares.

What is a Portfolio?

The term portfolio generally refers to a portfolio of shares and related investments such as cash in savings accounts, and derivative products such as single stock futures, etc. The question of asset allocation (i.e. how much of one's money should one invest in shares, property, cash, etc., is important particularly when conditions on the share market are volatile. Then one should increase one's level of liquidity (i.e. moving more into cash or near cash) until conditions on the share market improve. Most people have an indirect exposure to the share market through policies held with life assurance companies who are major investors on the share market. However, investing directly on the share market offers scope for higher returns.

Term

The essential question which investors have to ask themselves is: Am I a long-term investor or short-term trader? The investment term or duration of the investment has a direct or indirect impact on the investor. This term influences the type of investment that best suits your requirements and your anticipated returns.

  • Investors with a long-term perspective are aspiring for steady growth in income as well as asset value over time. This is done through ownership of a well-balanced and well-selected portfolio of assets that are considered to be reasonably secure. These investors can generally be classified as "buy and hold" investors. A portfolio is constructed and adjustments only made when absolutely necessary. This is a very sound strategy for any investor, provided that thorough research has been done and a well-diversified portfolio has been put in place. In the medium to long term a buy/hold strategy will almost always outpace inflation by a considerable margin. The investor also avoids excessive brokerage costs and the possibility of being classified as a dealer by the revenue authorities. This is the type of investment objective generally held by pension funds and long-term savings plans.

Some people may have a much shorter-term view and want to make a high degree of profits in a very short period of time, e.g. days, weeks or months. These strategies employed by such traders can be classified as either "jobbing" or "swing-trading".

  • Jobbing or speculating is a strategy enjoyed by bold speculators who seek a high degree of excitement from their stock exchange dealings. This strategy is basically the exact opposite of 'buy/hold'. Jobbing is the process of jumping in and out of investments, often taking advantage of very small price movements. It is, however, generally a very expensive way of operating for two important reasons. Firstly, the revenue authorities will have no hesitation in classifying you as a dealer. Furthermore, because you will be trading very actively, you will be paying substantial amounts in the form of broker's fees. Jobbing also requires that you keep your ear constantly to the ground and have an in-depth knowledge of the market. This can be very time consuming.
  • Swing trading is a more leisurely version of jobbing. In terms of swing trading you climb in at the bottom and jump out at the top, switching your entire equity investment to the money market, and awaiting the next opportunity to climb in at the bottom. In this strategy, your timing must be spot on. In theory it sounds great, but in practice only the fortunate few get their timing absolutely right.

Return

One of the main advantages of the share market is that you can choose from a wide range of risk/ benefit alternatives. All investments will involve you in both a risk and a return (either positive or negative). Even a Post Office savings account runs the risk of political collapse, for example. Basically, as you get safer with an investment, your potential return from it declines and vice versa. Beginners in the share market often feel obliged to 'take a view' on a share, and having done so they commit all or a large part of their portfolio to it. This approach is safe enough if you are looking at Anglo's or another bi 'blue chip' share, but if you are into the marginal gold shares then such a move could prove to be disastrous. The return on any investment accrues from income (interest or dividend distributions) and/or capital appreciation on the original amount invested. Thus, the essential question which investors have to ask themselves is:

What is more important to me; consistent income in the form of dividends and interest or long-term capital growth?

  • The anticipated return on any investment should be viewed in terms of the three criteria of risk, taxation and inflation. In this respect, one should bear in mind three rules of thumb:
  • The higher the potential return, the greater the potential risk.
  • The return should be expressed as a net-after-tax return.
  • The net-after-tax return on the investor's portfolio of investments should exceed the rate of inflation.

Let us examine some commonly held investments in relation to these three criteria.

  • Whilst keeping one's money in the bank may offer a reasonably high-income yield, it does not offer any capital growth. Whilst receipts of interest are fairly assured if one invests in a major bank, it should be borne in mind that all interest received is fully taxable.
  • Shares provide income in the form of dividends. Payments of such dividends are not assured - they are only declared when a company earns profit, and even then only upon agreement of the Board of Directors. In addition, shares do offer a high prospect for potential growth provided the company experiences sufficient growth over the years. In fact, historically, shares have shown a higher annual capital growth than bonds, cash, and property.
  • All income from property comes in the form of rental, which is taxable like interest. Such income is secure provided one has good tenants. Capital appreciation also varies considerably, but is greater where the property is situated in a fully developed area.
  • In the case of bonds, income takes the form of interest. This constitutes a major part of a bond's returns. Capital gains can only be achieved when the level of interest rates is falling. Thus, the longer the maturity date, and lower the coupon rate of the bond, the more sensitive it will be to interest rate levels. Short-term liquid bonds are thus considered to be less risky than long-term bonds.

Risk

What attract people to the share market is undoubtedly the potential for high returns, but this comes at a price. The price is the higher risk associated with share market investments compared to say a fixed deposit with a bank. As mentioned earlier, the general rule of thumb is that the higher the return the higher the risk. Thus, the essential questions which investors have to ask themselves here is:

  • Is the potential return worth the potential risk?
  • What are the chances of me losing money in this investment?

The degree of risk is said to be a function of the probability that the actual return received will be less than the return expected. The more volatile a return the more concerned one will be about downside moves.

As mentioned before, risk can take two forms:

  • Systematic risk which is the risk inherent in the market itself; and
  • Unsystematic risk which is the risk associated with the characteristics of any one particular type of investment.

In simple terms, returns do not correspond to total risk (systematic and unsystematic), but only to systematic risk. This is because unsystematic risk can be greatly reduced through portfolio strategies such as diversification, whereas systematic risk cannot.

In short, the risk will decrease as you invest in more shares. In fact it can even be shown mathematically that once you have more than 20 different shares in your portfolio, the addition of any further shares will only have a minimal effect on risk reduction, and in addition decrease your ability to earn greater returns (i.e. the more shares you include the more your returns will tend towards the average return for the market). Thus, the key lies in finding a balance between increasing one's number of shares to reduce risk and maintaining smaller numbers in order to maximise returns. In addition, systematic risk can, however, be hedged against by the use of derivatives such as futures and options or by diversification into other markets.

Stop-Loss Strategies

A fundamental objective of portfolio management is to limit risk. Anyone investing on the share market should be aware of the possibility of losses although this risk can be reduced by proper portfolio planning and following a sensible investment strategy. Experience, gained either on the share market itself or by following a training course such as this one, also helps to reduce the risk element.

Simple Stop-Loss Strategy

A stop-loss strategy is one basic principle to limit the risk by fixing the tolerable loss of an investment at the time that the investment is made. The simplest stop-loss strategy involves setting a sell level at a fixed percentage below the purchase price at the time of the purchase. A good stop-loss strategy would be to set your margin between 10 - 20%, excluding charges. For example, an investor is willing to accept up to a 10% loss on shares he buys for 1000c share, i.e. 10% of 1000c = 100c. The investor's stop-loss level will therefore be set at 900c (i.e. 1000c – 100c). If the share price falls to this level, 900c, the investor will automatically sell.

Some stockbrokers will accept stop-loss orders, which are automatically implemented in the market if prices fall. PSG Securities Ltd, for example offers such an automated stop-loss facility on our website. The fundamental principle of stop-loss strategies is that the stop-loss level can be moved up, but it can never be moved down. This ensures that risk is contained within a predetermined limit. Thus if the share price rises above its purchase price, the investor should hold onto the shares and, the stop loss is accordingly adjusted upwards.

In our above example, the price of the shares rises to 1500c. The stop loss percentage is now calculated against the new price level: i.e. 10% of 1500c = 150c. The investor's stop-loss level will therefore now be set at 1350c (i.e. 1500c – 150c). The new stop-loss level is now 450c higher than our original level. If the share price falls to 1350c or below, the investor will automatically sell. The greatest advantage of having a stop-loss strategy is thus that you can limit your downside losses while not restricting the upward potential in order to realise maximum profits.

Staggered Stop-Loss Strategy

Let us now extend the stop loss idea and include some additional concepts to make it more comprehensive and effective. The simple stop loss introduced above can be modified to allow for the rapid gains made in the share price. To accommodate these gains, the percentage of your stop loss increases at certain levels.

For example, start with a 10% stop loss until your share price is up by 50%, then switch to a stop loss of 15% for a 51% - 71% gain. Adjust your stop loss to 25% for an increase in the share price of 75% and over. This strategy works well for shares that rise sharply and then correct suddenly with profit taking, before recommencing a growth trend again. In the example below, a share is purchased at 100c, your stop loss is set at 10% or 90c. When the share price increases to 150c, i.e. a 50% gain over 100c, then the stop loss is increased to 15% of 150c (i.e. 128c). Once the share price reaches 175c the stop loss is set at 25% of 175c (i.e. 131c). Bear in mind, you can alter the percentages of your stop loss levels or the level at which the stop loss is changed. It is important to remember to never increase your stop loss percentage as the price is decreasing.

Target Stop-Loss Strategy

When using a fixed stop loss strategy of say 10%, it can (at times) kick you out of such a share because it falls 15% on sudden cooling market sentiment, despite the fact that it has risen 300% and can on to rise a further 500%. To avoid this situation, we recommend that you use a target stop loss as illustrated in the following diagram:

Here we have an imaginary share purchase at a particular price. A stop-loss level is set at 10% below the purchase price. The share price rises rapidly, but erratically, and the stop-loss level moves up behind the highest market price. The stop loss level will rise in line with the highest market price reached to date. After a time, the stop-loss level exceeds the price paid for the share. At this point (the break-even point) the trade is "in-the-money" and before it reaches this level it is "out-of-the-money".

Once your trade is "in-the-money" you should change your stop-loss. Change it from a simple percentage below the highest price reached to date, to an annualised target percentage growth rate. In other words, you should set a minimum growth rate in percentage terms for your portfolio, say 40% per annum. To calculate this, divide 40% by the 250 trading days of the year (i.e. 40/250 = 0.16% growth per trading day). This will give you a fraction of a percent by which the share must rise every day if it is to conform to your target. Make this your stop loss line. If the share is performing well above this level, then if it should fall 25%, you have discretion over whether or not to keep it. In other words, the area on the diagram between the share price and your target growth line is your discretionary area where you have the discretion to decide whether to hold or sell. The moment it moves below your target growth line, however, you must sell it because it no longer conforms to your investment objectives. At the end of the year, you may decide to increase your target to 50% and so you move your target stop loss upwards.

The process of gaining knowledge and experience in the share market should result in the learner steadily moving this line upwards until their share portfolio reaches too large a size to sustain large percentage growth rates. (i.e. the learner begins to experience the same constraints as institutional investors).

Dividends and Stop loss - One complication remains. On the day following the last day to register (LDR) for a dividend (also known as the ex-div date), the share price should fall by exactly the amount of the dividend to be paid. Such as sudden fall in the share price could push it through your stop loss level. Accordingly, your stop loss levels should be lowered by the amount of the dividend on the ex-div date. (Note: this is the only time that a stop loss level can be lowered.

Diversification

Diversification is a basic principle, (and probably the most important) for a sound investment strategy, and is a highly effective way of minimising unsystematic risk in the share market. As mentioned before risk in equity markets can be divided into two elements:

  • Systematic risk which is the risk inherent in the stock market itself; and
  • Unsystematic risk which is the risk associated with the characteristics of any one particular share.

Most investors are familiar with the idea that it is wise to hold several shares rather to have "all your eggs in one basket". The term diversification means to spread your capital among different shares and industries. The purpose of diversification is to limit your risk or vulnerability to adverse movements in any one particular share or industry. Diversification will not protect you from a general market slump. Studies in the United States have shown that as you increase the number of different companies in your portfolio, your risk declines, but to a lesser extent with each new share added. So, for example, if you hold just one share you are at great risk should that particular company have difficulties. When you add a second share, you reduce your risk considerably. The third share reduces your risk further, but not by as much as adding the second share. The fourth share reduces risk again, but by less than a third, and so on. The research study also indicated that at 15 different shares across 3 to 5 sectors, your reduction in risk by adding the sixteenth share was negligible.

Of course, each new share that you add increases the amount of research work that you must do, or rather spreads your time more thinly over your total portfolio. Portfolio diversification is, however, not without its disadvantages:

  • Few private investors can hope to keep abreast of the changing fortunes, misfortunes and potential of a large and varied portfolio consisting of, say, 30 companies in a variety of sectors.
  • The growth and returns of the better performing shares or sectors may be watered down by poorer performing ones.

Clearly there is a trade-off between reducing risk and spreading your time too thinly. We suggest that the optimum falls between 5 and 15 different shares. Fewer than five shares increases your risk to an unacceptable level, while more than fifteen shares makes your portfolio unwieldy, and will result in an inadequate amount of research on each share. In order to maximise performance while enjoying the protection of diversification, one needs to "concentrate" one's portfolio. It makes sense for the learner to decide on an optimum number of shares (within these parameters) to hold. We could call this your 'spread' of shares. If you assume, for a moment, that all shares which you decide to hold in your portfolio have exactly equal merit, then you would want to invest exactly the same amount in each. Thus, if your total portfolio capital is worth R120 000, and you choose to have a spread of 12 shares in your portfolio, then you would put R10000 into each share. We call this amount a 'portfolio unit'.

Obviously, all shares do not have equal merit and you will want to put more than one portfolio unit into a share from time to time. Suppose that you find a share which really excites you. The upside potential looks very good while the risk appears to be minimal. You decide, as a result, to put two portfolio units into that share. This means, of course, that you are doubly exposed to that share and we suggest that you should adjust your stop loss.

Here are other important points to bear in mind:

  • It should be noted that selecting just one sector could be almost as risky as selecting just one share. You should select a few sectors which look healthy and which fit into your overall investment strategy.
  • One of the biggest problems is that few private investors have sufficient capital to establish a well-constructed portfolio.
  • Even if one did have a large capital amount available for investment, it could be considered too risky to jump into the market "boots-and-all". If you were to invest a large capital sum in the market just before it takes a nose-dive, you would find yourself in a most anxious predicament.
  • Generally speaking, it is best to create a well-balanced portfolio over a judicious period of time. As you create your portfolio, you should take time to review it constantly. Keep watch on prices and check the financial press and other sources.

It is also essential to systematically review one's portfolio – either once a week or once a month. At each review you should ask yourself a series of questions, the answers to which should be supported by the facts. Some of these questions include:

  • Does the distribution of shares or sectors need adjusting in any way?
  • Does the distribution within my portfolio still tie in with my investment strategy?
  • Are performances in line with my expectations?
  • How does the latest information I have alter my expectations?
  • Is any action required? If all is well, leave well alone!

It is important to remain alert to any "rustle in the undergrowth" that signals a warning requiring immediate action by way of buying in or selling out. In the case of the former, one should always maintain a reasonable degree of liquidity. Be careful not to become too attached to a particular share or to compare its current price and yield to the original purchase prices, as this can often create a distorted picture. Once you have bought the share your decisions should be based on current information regarding the present or potential value of your shares and not the past purchase price. Once you have bought a share, forget about its purchase price!

Portfolio Structuring

Portfolio structuring is similar to diversification, but in another dimension: instead of spreading holdings across market sectors, portfolio structuring diversifies the portfolio in terms of quality and time frame. Without a structure, you will never be sure of how much money to put into a particular share, and you may end up with a portfolio that is too risky or too conservative. The classic traditional portfolio, for example, consists of a well-balanced selection of blue-chip quality shares that are held indefinitely. This type of portfolio tends to minimise risk, but it does not allow for exceptional returns. How should you go about structuring your portfolio for the best results? The sensible place to begin with any project is to carefully consider your objectives and limitations.

  • Your main objective is to minimise your risk whilst achieving the highest possible return over the long term.
  • Your limitations are the amount of time that you can afford to spend on analysing shares and the money that you have available to invest.

Everyone needs security, some more than others. Your need for security will partly determine how you go about structuring your portfolio. For example, a young person, with his entire earning life ahead of him, needs less security than a person in or nearing retirement. Portfolio structuring attempts to improve the return on a portfolio, without unduly increasing the risk. This is done by dividing the portfolio into three main elements, each having different time frames and focusing on different quality shares. The following three elements would be present in a typically structured portfolio:

  • The bulk of the portfolio (50 - 70%) should be in blue-chip shares with a 10-20 year view;
  • 20 - 40% should be placed in growth shares with a 3 - 10 year view; and
  • 10 - 30% should be used for active or speculative trading.

Blue Chip Shares

You should keep a portion of your funds in the 'blue chip', which are shares such as Liberty, First National Bank and SABMiller. These shares are usually in the Top 40 Index and are popular with the institutions. These shares also have enormous financial stability. A long history of sound management and good profits. You cannot expect dramatic growth or as the saying goes, "elephants do not gallop", as you have sacrificed that for security. Their capital value should, on average, keep up with the rate of inflation and beyond that you will receive a steady dividend income each year. This is not to say that blue chip shares will not provide exceptional growth. Take Barworld, for example. On the 8 June 2006 it was trading at 10300c - seven months later it had climbed by 83% to 18900c, which if annualised would be 142%. Similarly, retailer Truworths, nearly doubled from 1960c on 26 June 2006 to 3900c on the 16 April 2007. The JSE Overall Index increased by 53% over the same period, commendable enough return under any circumstances, but pale in comparison to some of the blue chips.

Growth or Green Chip Shares

Next, you should have some of your money in what are called secondary shares which are good quality, but slightly speculative shares. These shares are soundly managed and have excellent prospects but do not have the immense financial and historical stability of a share like SABMiller. By no mean stretch of the imagination could they be called blue chip shares, but they the potential to become blue chips in the future. They are not as well insulated against economic recessions as the blue chip shares are. In this area, you are looking for shares which could reasonably be expected to double their market price over the next two to three years. Having just given two examples above of blue chip shares which almost doubled in one year, investors might be tempted to stick with the blue chips and ignore the rest of the market. However, the examples cited above are rather exceptional - Barworld's share price was driven by a strong demand in cement sales (it owns a 67% stake in PPC) on the back of the building and construction boom, while Truworth was driven by strong consumer demand in a low interest rate environment.

Examples of growth or 'second line' shares are building materials company W G Wearne, listed on the Alternative Exchange (Alt-X), and Advtech, the education company. They are relatively young companies with a track record of excellent growth. Wearne appreciated from its low of 160c on listing in February 2006 to 620c in March 2007, nearly trebling its price. Advtech has been around a bit longer, moving from a low of 19c in 2001 to 425c in April 2007. Given the benefit of hindsight, investors would want to put all their money into shares such as Wearne and Advtech. However, it is important that we weigh our portfolio towards blue chip shares with perhaps 30% allocated to growth shares. Those who want to go for risk stakes could include some speculative shares, never more than about 10% of the total portfolio value, in speculative 'red chip' shares.

It is interesting to note that both "Growth Shares" and "Value Shares" are labels put upon a share by investors. Usually they represent styles in investing, and not all shares fit one category or the other. Looking for cheap shares is value investing, while the opposite of this is growth investing. Value investing is easier to define and explain simple benchmarks for buying under that premise. For example, a low P/E ratio often is considered a signal that a share is "cheap". An investor may buy that share on just that signal alone. The converse is not necessarily true. A "growth investor" does not usually buy a company simply because it is overpriced, but will usually look at how fast it is growing and what is expected in the future.

Many "value investors" will have considered their job of research over once they buy the share. If they bought a share for 1000c that they believe is really worth 1500c a share, then they have already made their profit and hope in the long run the market will adjust their value accordingly. Many "growth investors" will track their shares more closely in order to be able to adjust their predictions based on new information.

Speculative or Red Chip Shares

Speculative shares go under several other names such as high risk, dog shares, rubbish, lemons - anything uncomplimentary will generally do when referring to this class of share. They include venture capital and development capital shares, as well as marginal gold mines and other dubious operations. They have difficult financial positions and are generally frowned upon by the stock broking community and other conservative institutions. They are shares that pay little or no dividend, and you are certainly not interested in their dividend prospects. They have one merit only - they move! What we mean by this is that their share prices fluctuate widely on pure speculation or rumour. This makes it possible for the astute speculator or trader to buy them when they are out of favour and sell them a week or month later when their price is higher, only to repeat the process as the opportunity shows itself. You must accept that not everyone has the ability or strong nerves needed to 'play' the speculative shares.

To be effective in this area of 'trading' you must be totally 'on the ball'. You must follow your chosen 'specs' closely, looking at their price and volume traded each day and maybe even twice a day. If you cannot keep this close to the share then it is probably better not to get too involved in this type of share. Always ensure that your 'spec' has sufficient trading volume to make it reasonably free-dealing so that you can get out and then simply become familiar with its price movements. It is not wise to purchase more than a third of the average daily volume.

An example of a speculative share would be DRD Gold in the gold mining sector. It is a marginal or high-cost mining share. Before investing in a share such as this, you must take a view on the gold price. If you believe that the gold price is due to start kicking, then this share will eventually respond (but usually only after the more quality gold shares have started to move up). Had you bought into DRD Gold shares at the low of 420c in May 2005 and held them to the high of 1208c in January 2006, you would have made over 187% in less than a year! Be warned! These profits are rare and if you are caught holding these shares when the gold price is plummeting, you may not be able to sell until your profit is all but wiped out. DRD Gold share price subsequently fell to a low of 370c in March 2007, a drop of 69%. An important rule in trading speculative shares is never hang on for that extra profit too long. Had you bought DRD Gold shares at 500c and sold them at 1000c you would still have made 100%. Be pleased with that and never mind if someone else rides the share all the way to 1208c. When you make a profit with speculative shares, pass a percentage of it down the line to the more stable end of your portfolio. In this way, you will consistently be building up your portfolio in strong long-term shares.

So we have three areas:

  • A safe, long-term, low-return area;
  • A medium-term growth area; and
  • A high-risk, short-term area.

Time Allocation

Let us briefly consider how you should allocate your time over this portfolio structure and what you should take to your analysis in each section. As far as time is concerned, you should concentrate on the speculative or trading area and leave the blue chips to themselves. There is little point in spending hours over the balance sheet of Liberty as it is like the rock of Gibraltar.

Choose between 6 or 9 favourite blue chip shares and make long-term strategic decisions about them. For example, you may believe that energy is going to be short supply in five or ten years' time, so you would invest now in shares such as Sasol. Or you may feel that computers are the way of the future and invest in high technology shares. You should only transact your blue chip shares very occasionally, mostly accumulating them in periods of weakness and then holding them unless you have some major change of heart concerning a long-term strategic decision. Once you have chosen these shares do not spend too much time on them.

Growth or green chips are the shares that you feel have the potential to become blue chip shares. Here a balance of fundamental and technical analysis is used. Use your fundamental analysis (i.e. Value Filter on the PSG Securities Ltd website) to sift out the better growth shares and then use a technical analysis charting package such as the Wen Professional Plus to time the buying of the shares.

At the other end of the scale, your speculative trading shares must receive your concentrated attention and most of your time because this is where your risks are. Use your time and analysis to reduce the risk in this area to an acceptable level. Clearly also, your approach to speculative share trading must be largely technical analysis because their price fluctuations are caused by changing perceptions and 'mood of the market', rather than solid fundamental facts. Mostly, there is little point in spending too much time on the balance sheets of these shares because they tend to contain very little to look at! Fundamental analysis generally becomes more prevalent as your view becomes longer, and your shares become more like blue chips.

So put more attention on technical analysis when dealing with growth and speculative shares. One must never ignore the technical aspects of share trading. If one bought Anglo shares because of its sound financial performance and regardless of timing, you could end up paying 25% to 50% or more above the investor who times his purchase. Another point on speculative shares: in the past there were plenty of 'tips' and 'rumours' going around about various shares. Many were deliberate attempts to spread false information but since then the JSE has tightened controls for investor protection. Listen carefully and you will always pick up a rumour that this company has won a large order, or that company is being bought out. Be very careful of these snippets of what are often useless information. If you so inclined, check out the information with the company concerned. Yes, phone up the managing director or the company secretary who normally deals with shareholder issues, and ask them to confirm or deny the rumour. Remember, someone trying to off-load a particular share will go to great lengths to talk up the share price. You may end up being the patsy that takes the shares from him.

Liquidity

By now you may be asking yourself "what about keeping some cash available?" This is very important. Just as there are very few times you should be totally disinvested, there are few times when you should have no spare cash at all. Generally, you need to have cash to take advantage of any opportunities that may arise in the market. You should avoid being forced to sell a share at the wrong time in order to take advantage of an unexpected opportunity, such as a new issue. The amount of cash held will depend on the general state of the market. Obviously, if the JSE Overall Index is declining, you will want to be holding a higher portion of cash. As a guideline, the unit trust industry usually holds 10% to 20% of their portfolios in cash (they will always have a reasonable percentage in cash to pay out unit sellers and to take advantage of new buying opportunities). In conclusion, this approach to portfolio structure is put forward merely as a suggested framework and the exact split between the three areas varies considerably from person to person. But you should give a little thought to establishing your structure and consider each element carefully. This will determine how you allocate your key resources of time and money, and that, in turn, will determine how profitable you are. Remember that your biggest asses in the share market is time. You should always tailor your investment strategy according to the time you have available. Generally, the shorter your view of the market, the more time you will need to study your investments. If you have little time to devote to the market, adopt a long-term view. If you can devote considerable time to your investments, you can consider shorter-term trading. Similarly, you should not attempt to invest beyond your level of expertise. The shorter your view, the more skill you require to trade successfully. Do not trade short-term until you have the capability to do so.

Asset Allocation

Asset allocation is more a question of individual needs rather than a magical selection formula. All the above-mentioned factors must be taken into account in identifying the type of investment and the portfolio management strategies suitable for a particular investor. It is, however, helpful to examine the asset allocation adopted by pension funds as a guide to your own investment portfolio structure:

Bullish outlook for shares:
  • Shares - 65%
  • Property - 5 - 10%
  • Bonds -15 - 25%
  • Cash - 5 - 10%
Bearish outlook for shares:
  • Shares - 45%
  • Property - 5 - 10%
  • Bonds -25 - 45%
  • Cash - 5 - 10%

Once one has structured one's portfolio, it is essential to systematically review it - either once per week or once a month.

Rand-Cost Averaging

The timing of an investment in shares is just as important as selecting the right shares to buy. Rand-cost averaging refers to the process of investing a regular amount (normally on a monthly basis) in the market over a period of time in order to avoid the consequence of putting all one's investment capital into the market at what could unwittingly be the wrong time. By investing a certain amount of money regularly over a period of time, the average cost of the shares purchased will be lower than the average cost of the shares on the days on which they were bought. The reason is that a given amount of money will buy more shares at a time when the price is low than it will when it is high. The greater the fluctuations in the price at which the shares are bought, the lower the average purchase cost will be relative to the average share price.

Example: In the following example, investor A buys 100 shares in ABC Ltd each month while investor B invests a regular monthly amount of R100 in the same shares:

INVESTOR A

INVESTOR B

No. of Shares Bought

Amount Invested

Share Price
(in Cents

Amount Invested

No. of Shares Bought

100

R100

100

R100

100

100

R125

125

R100

80

100

R150

150

R100

67

100

R125

125

R100

80

100

R100

100

R100

100

100

R 75

75

R100

133

100

R 50

50

R100

200

100

R 75

75

R100

133

100

R100

100

R100

100

900

R900

100

R900

993

This example serves to illustrate a number of points:

  • The average price per share in the case of investor A is 100c compared to 90.6c in the case of Investor B.
  • The value (ignoring acquisition costs) of Investor A's portfolio amount to R900 on an investment of R900, while the value of Investor B's portfolio amounts to R993 on an investment of R900.
  • One could argue that a well-informed and 'clued-up' investor would have sold out when the share price was 150c/share and climbed back in when the price was 50c/share. That would amount to perfect timing.

What normally happens in practice, especially if one has invested a large or relatively large capital amount, is that while the share price is rising one is congratulating oneself for making such a wise and calculated purchase. When the price starts dipping one thinks that the original decision to buy couldn't have been wrong and that the fall is just a minor correction, soon to be reversed. The share price drops to the original purchase price and then falls below it. One can't then sell because that would amount to 'copping out' at a loss. The tension builds up as the price continues to fall, followed by relief, as the share price bottoms out and starts to climb again. Eventually, after what seems an eternity, the price edges up to the original purchase price and the investor bails out, thankful for being able to get his money back but worse off in terms of a return on his investment and in terms of the anxiety and stress that he has been subjected to during the downswing in the share price.

This example proves that unless your timing is perfect, it is better in the long run to invest in a regular amount than to buy the same number of shares regularly. Rand-cost averaging is most commonly implemented via a unit trust or portfolio management service, although there is nothing to stop an investor using this strategy while managing his own portfolio.

Averaging down after 'pulling a stop loss'

Subsequent to the purchase of a share, the share price begins falling and in the hope and belief that an upward correction is imminent you ignore your stop loss strategy and buy more shares at the lower price, thus bringing the average cost of the share down. The danger with this is that there is no limit to the downside of the price of a share if a stop loss is not implemented. You may buy into the share at various levels of its price decline until it has fallen to such a degree that you eventually sell it, possibly just before the price turns!

An example of this is when a share is purchased at 100c, goes up to 110c and then starts to fall gradually to a price of 80c your stop loss should have forced you to sell. Instead of selling, your emotions take over and you are unable to accept the pain of the stop loss, so you decide to buy shares at 80c in order to average your purchase price down to 90c. Over the next week the share price falls to 60c. You are now experiencing real emotional pain and again the impulse to average down is upon you, because you 'know' that the share cannot go any lower. You then buy a few more of these shares at 60c, bringing your average down to approximately 75c. By the time the share reaches 20c you are so emotionally bruised that you sell out in disgust and of course the following week the share turns and goes back to 50c.

Do not change the market to your thinking, but rather your thinking to the market. Believe what you see: you must admit that your original decision to buy was wrong, at least in its timing! The correct thing to have done was to have stopped out, waited for the share price to bottom and turn around and then to have bought in again. Consider the following. Had you stopped out, your downside would have been the brokerage cost of having to sell and buy again (± 3%). There is also the possibility of an 'opportunity cost' if the share price rises almost immediately after you have stopped out of the share. However, when one considers the risk of not using a stop loss and averaging down, it is far better to utilise the stop loss and only buy back into the share after it made its upward correction. This is especially true for active traders. For the long-term investor it is at times advisable to buy more shares with a rising share price, particularly after a big market correction.

A few important points

  • How long should you hold? - It does not really matter how long you hold your shares for, as some very successful investors have held their shares for 20 years or more, while others hold only for a few weeks, days or even hours. The less time that you have to study the market the longer you should hold for. Secondly, you must take into consideration the implications of Capital Gains Tax (CGT) should you decide to sell your shares.
  • When should you sell? - If you buy a share because you expect one thing to happen and that thing does not happen, then normally you should not wait for something else to happen. When conditions change drastically against you, sell sooner rather than later. It is normally true to say that your first loss will be your best loss. Another time that you should seriously consider selling is when a market or a share stops reacting to the favourable news.
  • When should you hold? - When your reasons for buying a share is still valid, but the share price drops on thin volume, you should continue to hold your shares. When the market is still reacting to favourable news you should hold on, and when the price is still rising on good volume, you should hold.

Conclusion

Structuring your share investment portfolio correctly and applying risk management strategies is essential for your success on the share market, as you would like to make money from here onwards by making the minimum mistakes and sleeping easy at night with minimum stress about your investment choices. The most important thing is to treat your investment on the share market in an impersonal way. An investment either performs the way you want it to or you must get rid of it! Losses on the share market will happen and the ability to accept losses is an absolute prerequisite for success on the share market. But to cling to shares that are just falling in price is not the right thing to do.

Use what you have learnt and get a feel for the market by doing your fundamental and technical analysis. Most investors understand that it is not always wise to 'put all your eggs in one basket', or all your money in one share, especially considering the high risks involved and the wide variety of investments available on the market. Therefore you will need insight into various factors that will help you select the best shares and thereby maximise your profits. The best way forward is the 'slowly-as-you-go approach' as it is too easy to become complacent and spend most of your life working for your money instead of making at least some of your money work for you. Technical analysis will benefit you as it has numerous technical indicators, which will aid you in your buying and selling decisions. Combine this with your knowledge of fundamental analysis and your share selection expertise and you will be a winner in the making!

Support

If you have any further queries, please feel free to contact our educational team on shaunvdb@psg.co.za or call 0860 PSG PSG (774 774).

Thank you for your support and happy trading!

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