IN SHORT Any financial advisor will tell you – don’t put all your eggs in one basket. We explain why.
In its simplest terms, investing means regularly putting your money into different assets — such as cash, shares, bonds, commodities and property — to grow over time.
While there are many asset types, like infrastructure and alternative investments, most everyday investors invest in shares, bonds and cash.
The main asset classes
Each asset class comes with its own level of risk and return.
Shares (also called equities)
When you buy a share, you own a small piece of a company. Shares are generally the riskiest asset class, but they also offer the highest potential for growth over the long term. Some shares are riskier than others, and their prices can move up and down a lot.
Bonds (also called fixed income)
Bonds are loans you make to governments or companies that they repay over time. They are usually less risky than shares, but riskier than cash. Bonds tend to offer more stable, moderate returns, but they are not completely risk-free.
Cash and cash equivalents
Cash includes savings accounts and money market funds. These are the least risky assets. They tend to hold their value and provide stability. However, over time, cash doesn’t keep up with inflation.
Understanding risk: tolerance and capacity
Every investor experiences risk differently. To understand how much risk is right for you, it helps to look at two things:
Risk tolerance. This is how much risk you are emotionally comfortable taking. If big ups and downs in your investments would cause stress or panic, you may have a low risk tolerance. This can change over time.
Risk capacity. This is how much risk you can financially afford to take. If a big loss would stop you from reaching your goals — like buying a home or retiring comfortably — your risk capacity may be low.
Together, your risk tolerance and risk capacity form your risk profile, which helps guide your investment choices.
Nolwazi explains….
Kabelo invests R500 a month in an investment on the stock exchange. Over time, his investment grows to R20 000.
After bad news about corruption at several large companies, the value of his investment drops to R15 000.
Kabelo feels uncomfortable seeing the drop, but he does not panic or sell. He knows he only needs the money in five years to help pay for his child’s education, so he can afford to wait for the investment to recover.
This shows:
- Risk tolerance: Kabelo can stay calm when his investment loses value.
- Risk capacity: He does not need the money right now, so he can afford to take short-term losses.
Asset allocation and diversification
Because different asset classes behave differently, investors usually don’t put all their money into one type of asset i.e. they don’t put all their eggs in one basket.
Asset allocation is how you spread your money across various asset classes, such as shares, bonds and cash.
Diversification goes a step further by spreading your money across different investments within each asset class.
Why diversification matters
Different assets react differently to economic and market events. When one asset class is performing badly, another may be doing well. By spreading your investments, you can reduce the impact that any single market event has on your overall portfolio. Below, you can see how different market conditions affect the different asset classes:
The foundation of investing
Assets, risk and diversification are the three building blocks of investing. They help you decide:
What to invest in
How much risk to take
How to spread your money
Once you understand these basics, you’re better prepared to build an investment portfolio that suits your goals and your life stage.
Further reading
Investment fundamentals: 5 things about investing
It’s all about compound interest
Saving vs investing
Sources
Manulife: The investment basics of asset allocation vs diversification
Ameriprise: Diversification and asset allocation
The graphs are for illustrative purposes only. Neither asset allocation or diversification guarantees profit or eliminates the risk of loss.
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