Ultima Financial Planners - News

Some ten years ago when I entered the investment world I had a fascinating discussion with my grandmother. She taught me the very important lesson of not putting all your eggs in one basket. This she explained was the key to investment success as it reduced your risk dramatically.

To illustrate the point she explained that she had split her investments equally amongst four banks. All the money was on call or in a fixed deposit depending on the rates payable by the various banks. This spreading of her risk made perfect sense to me. It was only a while later that I came to terms with her error. The error was that she had not spread her risk at all.

Putting your eggs in two baskets is not good enough. You need to put your eggs in a basket and a padded box. The basket may be able to carry more, but the box is safer. If you fall carrying two baskets the dangers are equally great. With a padded box you will be a lot safer but will not be able to carry that many eggs. This is more appropriate spreading of risk.

My grandmother should have diversified away from just having all her money in the bank by putting some into equities, property or fixed interest securities as well. This would have provided effective diversification for her. True diversification requires spreading your assets among investments with different characteristics that will react differently to each other. The biggest challenge in diversification of an investment portfolio is accepting that you will have an underperforming investment within your portfolio. If not you have not diversified properly, you are heading for disaster. A properly diversified portfolio must have an underperforming component to it. Appreciate its benefits.

Investment diversification is appropriately illustrated by the ice cream seller at the waterfront. On warm days visitors form long queues to buy an ice cream from him. To earn extra income and reduce his risk he decides to diversify his business and sell cooldrinks as well. By doing this he increases his income slightly because some patrons buy both an ice-cream and a cool drink and non ice-cream eaters are now buying his drinks. He is now content that he has added another product line to his business. However, this additional product line will not solve his problem on a cold day when people want neither ice-cream nor cooldrinks. usiness risk. Instead of selling cooldrinks he should sell hot chocolate. By doing this he could sell hot chocolate on cold days and ice cream on hot days. This is effective diversification. He will now have a business that will be able to generate him an income every day, all year round.

Not earning any income on cold days is a major business risk. Instead of selling cooldrinks he should sell hot chocolate. By doing this he could sell hot chocolate on cold days and ice cream on hot days. This is effective diversification. He will now have a business that will be able to generate him an income every day, all year round.

If only life was this simple. He does not have limitless cash to ensure that he has sufficient stocks of ice-cream and hot chocolate for most extremes of weather conditions. How can he be one step ahead of the game and keep the right balance of stock? If there were an equal number of warm days to cold days it would be easy for him to spend half his money on ice-cream and the other half on hot chocolate. However this is not always easy. Cape Town weather can be unpredictable at best. He needs to do some planning and obtain information on the average number of hot and cold days per year and buy his stocks accordingly. To be smarter he should get these statistics per season, then per month and act accordingly. If six out of ten days are cold, six out of ten rand should be spent on hot chocolate and only four out of ten rand on ice-cream. This will help achieve the right blend of stock he needs to keep.

Even the best stock management system is not going to cater for “scorchers” and “freezers”. On these days he will curse that he had not got more ice-creams or hot chocolate while he is sitting with spare stock of the other product. But in berating himself he remembers that the alternative is just to sell ice-cream or just to sell hot chocolate. By adopting that approach he is going to have days when he could have made more, but also days when he makes absolutely nothing. By blending the two he is getting the best of both worlds although there will be times when he misses out on the jackpot. In the long run he has a better business and will make more money by diversifying effectively, even though at times if he had just stuck to ice-cream or hot chocolate that would have been better for him.

Most of us would have done the same if we were running the business. If this is so self evident why do we not apply this philosophy to our wealth creation strategy? All we need to do is replace hot chocolate and ice-cream with cash and equities.
There are times when you should have had equities on your shelf and there are times when you needed cash. Invariably these times differ and it is exceptionally difficult to determine when those times will be. With “appropriate” research you can do better than just guessing. It makes a great deal more sense however to have a blend between the two. You will miss the peaks but you will also miss the troughs. This balance will reduce your risk and effectively diversify your portfolio for better long-term returns. Remember there will be times that you are not selling ice-creams or not selling hot chocolate. However, you need to have them in stock because we do not know what tomorrow’s weather holds.

Don’t waver in your strategy. It will bring long-term success!

This newsletter will find you in the midst of great volatility in the investment markets. Over the last five years we have often informed you of great principles to follow when markets take a turn for the worse. Although such times are never easy, it is precisely the time to stick to a proven investment strategy. We chose to appoint acsis as our portfolio advisors during 1999 because we embraced their investment philosophy and the principles they have applied to their portfolios since 1982. The choice to align with acsis has been vindicated, as we now have a track record in South Africa of almost 10 years.

It is during current times of volatility that we need to assess the basic principles of the acsis philosophy as described by the CEO of ipac Australia, Arun Abey, in his book How much is enough.

How do quality, value, diversity and time work?

QUALITY

First and most significantly, there is always a clearly identifiable reason why quality companies make profits and pay dividends and do so consistently. They are not slaves to market fashion. Typical attributes include sound longer-term earning potential, good returns on equity, capable management with a solid track record, a sound balance sheet and reliable core business franchises. They can be household names like Coca-Cola and IBM.

VALUE

The second principle of sensible investing, value, is a function of quality and price. There is a danger that shares in good, quality companies can be bid up to such high prices by optimistic investors that they cease to be good value.

Some of the most dangerous words in investment are, “You can’t go wrong buying…”. Some of the worst disasters have arisen from people paying too much for what are essentially quality assets.

Australian entrepreneur Alan Bond learned this the hard way. In the mid-1980s he bought Australia’s Nine TV Network from media mogul Kerry Packer for a huge sum. Within a few short years he sold it back to Packer for a fraction of the price. The Nine Network was a quality company both when Bond bought it and when he sold it. The difference was that Packer better understood its value.

The key to assessing value and quality is to know whether the asset can produce an attractive return, relative to its risk.

DIVERSITY

Diversification is such an obvious strategy that it is remarkable that so few investors follow it. It simply involves having investments across different asset classes, countries and funds. While many people start investing in a diversified portfolio, what typically happens is that they end up concentrating on those investments that have delivered the best returns. They gradually weed out investments that have suffered a bad 6–12 months. The portfolio is left with a few investments that have delivered high returns. Such behaviour was typical during the tech-bubble period. But when the crunch came, the result was devastating. For investors who retained small holdings in the affected companies and held a range of other investments, the impact was far less. Diversification is important because it provides access to a wide range of investment opportunities rather than focusing on one or two.

TIME

The ultimate test of a successful portfolio comes with time, and it is here that the numbers do tell the story. While the first three of the four principles were not fully rewarded in the late 1990s, they emerged once again with the collapse of the technology stock bubble. Investors who focused on the broader share market still suffered during one of the worst bear markets in history, but the pain was far less severe and the recovery far swifter. We also know that over the longer term, the stock market produced returns of inflation plus 7,5%. If we thus have a properly, scientifically diversified portfolio and our time horizon is more than 7 years we can expect to have the returns that will help us achieve our investment objective. We are proud to say that this is exactly what our strategic relationship with acsis has produced since inception in 1997.