CH 8: Investment

Investment

When considering investment opportunities, it's important to evaluate which options best suit an individual or business using specific criteria.

Criteria for Evaluating Investment Options

  • Risk: The level of uncertainty and potential for loss.
  • Return on Investment (ROI): A measure of the efficiency of an investment; the return an investor gets above the original investment.
  • Time Frames: The duration of the investment.
Risk
  • High-Risk Investments:
    • Potential for higher returns if successful.
    • Possibility of significant losses if the investment fails.
    • Example: Betting on "red" at a roulette table involves high risk for potentially high return, or complete loss.
  • Diversification:
    • Spreading investments across different assets to mitigate risk.
    • Avoid putting all resources into a single investment vehicle.
  • Investors can choose the degree of risk based on their preferences and circumstances.
Return on Investment (ROI)
  • ROI measures the efficiency of an investment.
  • It indicates the return an investor receives above their initial investment.
Time Lines
  • Longer Investment Periods:
    • Allow investors to take on greater risks due to more time to recover potential losses.
    • Example: A 20-year-old saving for retirement has 45 years to recover losses.
  • Shorter Investment Periods:
    • Require a more conservative approach to avoid significant losses close to the target date.
    • Example: A 50-year-old saving for retirement has less time to recover losses and should avoid high-risk investments.
Investment Strategies
  • High-Risk Investment Strategy
    • Focus: Long-term capital growth rather than monthly income.
    • Example: Investing in shares on the JSE, potentially blue-chip shares to reduce risk.
  • Growth Investment Strategy
    • Risk: Medium.
    • Aim: Capital growth with some monthly income.
    • Example: Combination of equities and interest-bearing investments like fixed deposits or property with rental income.
  • Balanced Investment Strategy
    • Risk: Low.
    • Emphasis: Monthly income with some capital growth.
    • Example: Investments in property and bank deposits, with a smaller portion in equities.
  • Conservative Investment Strategy
    • Risk: Averse to risk.
    • Focus: Monthly income while preserving capital.
    • Example: Primarily property and cash instruments, aiming for capital growth through property appreciation.

Investment Options / Instruments

Equities / Shares
  • Description:
    • Represent ownership in a company.
    • Can be listed on the JSE or unlisted.
    • Focus is on listed companies due to readily available performance information.
    • Shareholders own a portion of the business.
  • Methods to Become a Shareholder:
    • Buying shares directly from the company during initial issuance, providing capital to the business.
    • Buying shares on the JSE from existing shareholders, which does not impact the company's capital.
  • Risk:
    • JSE has strict rules to protect investors.
    • Equities are considered moderate to high-risk investments.
    • Blue-chip shares are shares in high-end companies and have lower risk and higher ROI.
    • Investors usually take smaller risks than speculators.
  • Return on Investment (ROI):
    • Factors contributing to ROI:
      • Increase in share price (capital growth).
      • Dividends (company profits distributed to shareholders, not taxed in South Africa).
      • Ideally, a combination of both.
    • Shareholders expect:
      • Increase in share price over time.
      • Consistent dividend payments.
      • Performance that beats inflation.
  • Share Price Determination:
    • Market forces (demand and supply).
    • Factors impacting demand and share price:
      • Confidence in the economy (bull vs. bear market).
      • Government policies or new legislation like nationalization speculation.
      • Industry performance (positive or negative publicity).
      • Financial performance of the business (sales, profits, ratios, dividends).
      • Management confidence.
      • Social issues (environmental impact, CSR).
      • Legal issues (lawsuits, price fixing).
      • Media coverage (perceptions of the country, industry, and company).
  • Time Frame of the Investment:
    • Investors: Aim for long-term capital growth and reinvest dividends in blue-chip shares.
    • Speculators: Seek quick and significant increases in share price for short-term profit, with less concern for dividends.
Debentures
  • Description:
    • Also known as bonds (but different from mortgage bonds).
    • A letter of credit ("IOU") used by businesses to raise capital for large projects.
    • Usually unsecured by specific assets.
    • Debenture holders receive interest.
    • Higher-risk businesses must offer higher interest rates.
    • Debentures can be sold on the JSE.
  • Types of Debentures:
    • Redeemable: Repayable on a predetermined date.
    • Irredeemable: Never paid back, with perpetual interest payments.
    • Convertible: Converted into shares at a future date.
  • Risk:
    • Fixed interest rates can be advantageous if interest rates drop, but disadvantageous if they rise.
    • Variable interest rates (linked to prime) mitigate this risk.
    • Risk of business bankruptcy.
    • Higher risk than bank investments, lower risk than shares.
  • Return on Investment (ROI):
    • The issuing company is legally obliged to pay interest.
    • No capital growth.
    • Higher interest rates compensate for higher risk.
    • Interest income is taxable, and after-tax ROI may not beat inflation.
  • Time Frame of the Investment:
    • Used as a long-term financial instrument for earning interest until redemption.
Retirement Annuities and Pension Funds
  • Description:
    • Retirement Annuity (RA): A policy providing income after age 55, with premiums receiving tax relief.
    • Pension Funds: Pooled contributions from employees managed by a fund administrator to grow and exceed inflation, with contributions deducted before taxable income.
  • Risk:
    • Depends on investment decisions made by administrators.
    • Helps manage the risk of insufficient retirement income.
  • Reasons for Insufficient Retirement Provision:
    • Delaying saving for retirement.
    • Increased life expectancy requiring longer provision.
    • Higher healthcare costs in old age.
    • Loss of employment benefits upon retirement.
    • Spending payouts from previous pension funds instead of reinvesting.
  • Additional Benefits:
    • Pension funds offer cover for death and disability.
  • Return on Investment (ROI):
    • Determined by the investment manager's decisions.
    • No guarantees; compare guaranteed ROI to inflation.
    • Funds often provide optimistic predictions.
    • Administrative costs and management fees reduce ROI.
  • Time Frame of the Investment:
    • Start as early as possible and maintain throughout employment (40-45 years).
Endowments
  • Description:
    • A form of long-term saving with lump sum investments and/or monthly contributions.
Unit Trusts
  • Medium to long-term investment. Good unit trust investments will outperform inflation over a 3-5 year period. Rate of return will depend on the risk option chosen and how well the fund manager performed.
Collectibles
  • Description:
    • Examples: Antiques, coins, artwork, stamps, jewellery and Kruger Rands.
    • Requires understanding of the market.
    • South African market is limited but improving with technology.
    • Requires expertise.
  • Risk:
    • Damage can drastically reduce value.
  • Return on Investment (ROI):
    • Value increases over time if it is a true collectable.
    • No monthly income for the investor.
  • Time Frame of the Investment:
    • Generally shows growth over a long period.
    • Short-term profits are possible but are the exception.
Notice Deposits
Fixed Deposits
  • Description:
    • A fixed amount is invested for a fixed time at a fixed or variable interest rate.
    • Withdrawals before maturity incur penalties.
  • Risk:
    • Low risk but banks can be liquidated, although rare.
  • Return on Investment (ROI):
    • Interest rate varies based on the bank and amount invested.
    • Aims to exceed inflation, but often does not.
    • Capital growth is achieved if interest is capitalised (re-invested).
    • Low return on investment.
  • Time Frame of the Investment:
    • From a year to 10 years or longer the longer the term, the higher the interest rate.
Money Market Accounts
  • Description:
    • A short-term investment that is liquid.
    • Example: call account with a notice period for withdrawals like a 32-day call account.
  • Risk and Return on Investment (ROI):
    • Low risk with lower interest rates than longer-term investments.
    • Interest rate is better than normal savings accounts.
  • Time Frame of the Investment:
    • A short-term investment of about a month to a year.
Fixed Property
  • Description:
    • Refers to land and buildings.
    • Can be residential (house or flat) or commercial (offices, shopping center).
  • Risk:
    • Location.
    • State of the economy: Higher interest rates or high inflation increase risk.
    • Capital Gains Tax (CGT) applies to profits on sales, except for primary residences.
  • Return on Investment (ROI):
    • Charging rent on investment properties.
    • Property prices increase over time.
  • Time Frame of the Investment:
    • A long-term investment. Prices do not increase quickly.