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Financial Planning 3A
Investment Planning

30/03/2021

Introduction
• Investment
 Compensation for time, inflation and investment risk
 Financial assets – classified into 4 major asset classes (cash, bonds, shares & property)

• Portfolio Management Process

 Moves from planning, through execution and then to feedback

• Investment Policy Statement

 Return objectives
 Risk objectives
 Constraints

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Investment Process

Footnote 3

Investment Risk and Return

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Equities – Historical Long-term Performance

• Equity – JSE Top 40 Index

 Largest of all indices (top 40 of
largest listed companies)

 Performance of shares provides

an average return

 Some shares do better - others

worse

 Over long-term, equities

outperform other asset classes
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Equities – Historical Long-term Performance

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Investment Risk and Return

• Measuring Investment Return

 Nominal rate of return = gross return before tax and inflation

 Real rate of return = [(1 + nominal) / (1 + inflation)] – 1

 Real return after tax = Return x (1 – tax rate)

 Before tax return = Return / (1 – tax rate)

Footnote 7

Investment Risk and Return

• Measuring Investment Risk

 Standard deviation = possible range of outcomes around the expected return

 Beta = measure of volatility of a security/portfolio in comparison to the market as a whole

 Alpha = return that is unique to particular asset or portfolio and which cannot be explained by

market or systematic risk

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Individual Investors - Characteristics

• Situational profiling
 Source of wealth – entrepreneurs exhibit higher level of risk taking
 Measure of wealth – financial well-being is subjective – can’t categorise based on net-worth
 Stage of life – accumulation, maintenance & distribution phases
• Psychological profiling
 Traditional finance – investors are rational, information-based & have dispassionate objectives
 Behavioral finance
 Loss aversion
If there’s prospect of certain loss (e.g. R500), people choose uncertain loss (e.g. R1K or R0) – HIGH RISK
If there’s prospect of uncertain gain (e.g. R1K or R0), people choose certain gain (e.g. R500) – LOW RISK
 Biased expectations
Results from cognitive errors & misplaced confidence in one’s ability to assess the future
 Asset segregation
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Individual Investors - Characteristics

• Psychological profiling (behavioral finance) – continued
 Personality typing

DECISIONS MAINLY DECISIONS MAINLY

BASED ON THINKING BASED ON FEELING

More Risk Averse METHODICAL CAUTIOUS

Less Risk Averse INDIVIDUALIST SPONTANEOUS

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The Conservative Investor

• The conservative investor is looking for long-term capital preservation, protected from
extreme fluctuations in volatility
• They are heavily invested in bonds and cash
• Capital is maintained and there is little potential for growth

15%

Bonds
30% 55% Cash
Equity

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The Moderate Investor

• The moderate investor is looking for both income and growth

• The equity content dominates the bond and cash content
• The portfolio is less volatile than the market as a whole

35%
Bonds
Cash
55% Equity

10%

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The Aggressive Investor

• The aggressive investor is looking for a high level of aggressive growth

• They invest in shares of companies showing a high growth potential
• Portfolio is highly volatile resulting in the investor requiring a long-term approach to the
investment.
10%
5%

Bonds
Cash
Equity

85%

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Investment Policy Statement - Objectives

• Return
 Distinguish between return requirement and return desire
 Total return approach – annual after-tax return necessary to meet investment goals

• Risk
 Ability to take risk
 Suited to quantitative assessment – planner should define terms of analysis
 Determined by financial goals relative to resources & time within which to meet goals

 Willingness to take risk

 More subjective assessment
 Psychological profiling provides estimates of individual’s willingness to take risk – but imprecise
science…

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Investment Policy Statement - Constraints

Time Horizon
• No universal definition of long-term or short-term – however, generally
 10 – 20 years = long-term
 03 – 10 years = intermediate-term
 00 – 03 years = short-term

• Can be single stage or multi-stage time horizon

• Stage of life investments assume that time horizon shortens gradually as life stages change
• If client has grandchildren – circumstances may determine investment goals & time horizon
• If a person needs an income during their working lives (e.g. 10 years) and assumes that they
will live another 15 years after retirement, their investment time horizon is multi-staged (viz.
– 10 and 15 years)

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Stages of life

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Investment Policy Statement - Constraints

Liquidity
• Ability to efficiently meet anticipated & unanticipated demands for cash
 Transaction costs – e.g. brokerage fees – early disinvestment penalty
 Price volatility – lowers certainty with which cash can be realised efficiently

• Liquidity requirements
 Ongoing expenses – use high degree of liquidity in investment portfolio
 Emergency reserves – can range from 3 – 6 months
 Negative liquidity events – e.g. unplanned birth of a child
 Positive liquidity events should be noted in the IPS – e.g. anticipated inheritance

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Investment Policy Statement - Constraints

Taxation
• Use tax concessions such as interest and dividend exemptions

• Consider income tax and capital gains tax implications on investment vehicles
• Defer tax to avoid impact of diminishing benefit of compounding returns
• Tax avoidance
 Consider tax-exempt securities - although typically offer lower returns
 Some tax-sheltered savings have a minimum holding period – e.g. Endowments
• Wealth transfer
 Transfer at death – Estate Duty implications
 Early transfers – consider gifts to grandchildren to skip generation of transfer
taxes
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Investment Policy Statement

Legal and Regulatory Requirements - Constraints

• Often involve taxation and transfer of personal property ownership through

 Trusts
 Family foundations

Unique Circumstances – Constraints

• Does the client have dependants

• Does the client want their dependants to benefit from capital - e.g. disabled child
• Do they want the capital to be extinguished at death
• Religious, ethical and social responsibility considerations

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Collective investment schemes

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Collective Investment Schemes

• Investors require a unique portfolio based on their investment objectives

• Whilst many asset classes exist in this regard, direct investments in shares, bonds,
property may be very costly to an individual

• Collective investment schemes exist to bridge that gap

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What is a Collective Investment Scheme?

• A collective investment scheme pools the money of a number of investors who want to invest in
bonds, shares and money market instruments

• The total fund is divided into individual units containing the same portion of assets as the fund

• Offers full time management by professionals

• Investors may purchase participatory interests in the collective investment scheme portfolio, by
doing so the investors participate proportionately in the income and profits of that managed portfolio

• Allows for power of compounding (where income can be automatically reinvested)

• Allows for monthly or once off investments

• Governed by the Collective Investment Schemes Control Act (CISCA) which replaced the unit trust
control act

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Types of Collective Investment Schemes

• Unit trusts

• Hedge funds

• Open ended investment schemes

• Participatory bonds

• Collective investment schemes in property

• Offshore investment schemes

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Collective Investment Schemes - Pricing of Participatory nterest

Maximum fee Annual effective Lowest selling
charged as a yield on the price per unit
Name of the percentage of fund over the past
fund by the Net Asset 12 months
manager Value

FUND NAME FEE NAV YIEL CPU HIGH LOW

D
Allrounder 4.56 226.96 2.93 225.85 125.37
Balanced 5.70 223.14 5.38 224.67 135.22
Bond 1.14 122.53 8.63 10.00 125.46 108.81
Cautious 5.70 125.26 8.19 126.46 102.39
Total amount in
Net Asset Highest selling
cents paid out
Value of a unit price per unit
over the past
if the fund over the past
12 months
twelve months

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Economics

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Business Cycle
• Phases of the Business Cycle
 Economies experience cycles in economic activity - recurring intervals of
economic expansion followed by times of recession
 These cycles are termed business cycles
 Are defined as recurrent but non-periodic fluctuations in the general business
activity of an economy
 Each cycle consisting of four phases
 A lower turning point (or trough)
 An expansion
 An upper turning point (or peak)
 And a contraction

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Business Cycle

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The Business Cycle

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Business Cycle – Expansion Phase

• Period of economic prosperity and growth
 Aggregate demand increases
 Firms’ inventories are run down
 Production increases at a faster rate than aggregate demand as inventories are
rebuilt
 Businesses employ unemployed workers who spend their income on consumer
goods - This generates more demand and businesses employ more people
• The process continues until businesses encounter capacity constraints
• If firms expect continued increasing demand they will invest in capital goods - plants,
factories, machinery and equipment
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Business Cycle – Expansion Phase

• Consumer demand will increase on the back of the increased demand for
capital goods as firms producing capital goods employ more labour

• In addition demand for investment funds increases

• Production eventually reaches a ceiling due to supply constraints and

bottlenecks - the upper turning point is reached

• The demand for investment funds puts upward pressure on interest

rates and new investment is no longer profitable

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Business Cycle – Contraction Phase

• As investment demand falls, producers of capital goods lay off workers
• Increased unemployment results in decreased consumer spending – businesses
producing consumer goods and services cut down on production and employment.
• The trough or lower turning point is reached when production decreases to some
minimum level
• At this level consumer demand is steady as workers employed by the government
or in industries producing essential goods and services such as food and utilities
retain their jobs
• Slack demand for investment funds has resulted in a fall in interest rates
making new or replacement investment profitable – at least for firms providing
essentials
• With steady consumer demand, increase in investment demand will begin the lift
the economy again
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Business Cycle - Summary

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Business Cycle - Summary

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Investments and the Business Cycle

2 6
3 JSE
Business Cycle

1 4 5

1. Low economic activity – low interest rates - Strong demand – unaware of potential
2. Strong growth in earnings – investors reacts enthusiastically –increase J.S.E.
3. Demand in economy starts to weaken, interest rates under pressure, inflationary
pressure – investors still reacting enthusiastically
4. Economy stagnant, earnings disappointment, investors negative and realise losses
– move back to money market
5. Back to 1 – investors not interested in JSE and remains in money market

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Business Cycle – Asset Class Performance

• Shares
 Tend to perform best during both the recovery and expansion phases when
economic conditions are improving and company revenues are increasing

 Volatile at the upper turning point of the cycle as investors become less certain
about the future

 Prices decline during the contraction phase of the cycle when economic
conditions are less desirable and corporate profits are falling

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Business Cycle – Asset Class Performance

• Bonds
 Likely to perform well during the contraction phase and lower turning point when interest
rates generally decline
 Tend to perform less well during the late expansion phase and upper turning point when
interest rates are rising

• Property
 Tends to perform well during recovery and expansion when interest rates are relatively
low and employment and economic conditions are improving
 Tend to perform less well during the contraction phase when economic conditions are
deteriorating, employment is declining & interest rates are increasing

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Business Cycle – Asset Class Performance

• Cash is generally more attractive during the contraction phase when economic
conditions are worsening and there is widespread pessimism, particularly in the
business sector

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Business Cycle – Asset Class Performance

• Commodities
 Likely to perform well during the expansion phase of the business cycle when
production is increasing rapidly; production capacity is at or near full utilization and
demand for commodities is high
 Perform less well during contraction when manufacturers are reducing production and
demand for commodities is low
• Commodity precious metals
 Tend to perform best during the upper turning point when the demand for precious
metals like gold, platinum and silver rises for industrial purposes and as a hedge
against inflation
 Tend to perform less well during the contraction phase, when industrial demand is
low and inflation is declining

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