Following my previous discussion presented in the letter “basics of investing” I now discuss the methods and styles used in managing share portfolios and or funds and then what asset allocations are apportioned within these portfolios or funds.
Value versus Growth
The financial services industry and the unit trust industry in particular have always been awash with theories about how best to maximize returns while minimizing risk. As managers and advisors strive to create ever more complex models on which to base their decisions, it is often the basics that get overlooked.
We know well, that past performance is not an accurate guide to future performance and yet we continue to rely on this measure as an indicator of what we are likely to get back from our investments in the future, but what about style? A manager's investment style can, over the long term, make a real difference to the returns achieved on an investment but until recently this important aspect has been much overlooked.
What is style?
Most asset managers tend to favor a path somewhere between the two, but it is the degree to which managers follow these opposing styles which will, it has been shown, determine the success of their investments over time.
In simple terms a 'growth manager' will look at a range of company shares and attempt to predict which of those shares is likely to rise in the future. The growth manager will then buy the shares of those companies he thinks most likely to rise, regardless of the underlying valuation of the company in the hope that they will indeed increase in price. A value manager on the other hand will look at a range of stocks and attempt to determine which shares are 'cheap' relative to the underlying value of the company. The value style of management relies on the belief that markets are not perfect and stocks are often miss-priced. The skill lies in identifying those stocks that are cheap because their true value has yet to be identified, as opposed to those that are cheap for good reason.
Value or Growth
Many independent studies have been conducted to identify which style will deliver the best returns over time. Without exception, all have identified value as the clear winner over every significant time period. If this were true, however, why is it that the majority of fund managers declare themselves to be Growth managers?
The explanation is simple yet revealing. By nature growth managers tend to be competing with each other to buy the same stocks. Value managers on the other hand, tend to be more contrarian, looking for stocks which have not yet been identified by others and then holding them until their price rises to 'fair value' at which point the share is sold. (Just at the point at which a growth manager would buy in the hope of further rises). Adopting this style requires conviction on the part of the fund manager that his research is accurate and his decisions valid, without the support of market consensus to reassure.
Asset allocation is the process by which investors decide what proportion of their portfolio should be invested in different types of investments.
The theory behind this is that by diversifying among different asset classes, an investment portfolio can be constructed that has less risk than the weighted average of its component parts. In other words, different asset classes move up and down at different times.
Once you have an idea of your risk profile, you can choose the type of portfolio to aim for. It is important that this decision is reviewed on an annual basis as your needs and profile can change.
One of the most popular formulas designed to provide a stage of life allocation - the age method - is to subtract your age from 100 to determine your share percentage, put 10% in cash and the remainder in bonds.
The next method that can be used is the resource / goal method. Here you would need to determine your time horizon. The longer the period (time) the greater the share allocation. Money that is needed in the short term should not be invested into shares.
Next you would choose the asset class and your risk profile would help you choose the assets for the portfolio.
Lastly you would need to determine how much of the portfolio to invest in each asset class so that the targeted return can be achieved.
It is important to examine the "downside risk" or the amount you might lose in a year for your specific portfolio. In other words, find out how bad the worst years have been.
In South Africa a minimum of 25% of your retirement portfolio must be invested into cash, bonds or a combination of the two.