Keeping-it-simple diversification

Diversification is the way to reduce your investment risk and enhance your returns – if one investment delivers poorly this should be offset by better performance from the others you hold.  

The merits of investing in an increasingly broad array of asset classes are often highlighted and investors are encouraged to invest across funds, sectors, themes and countries.

But you can keep it simple and invest in just two asset classes – cash in the form of a very low-risk money market account and South African shares in an index that tracks the local market like the JSE Top 40 index.

Behavioural finance shows how readily people are confused by complexity. In decision-making experiments, adding a third option to two alternatives causes between 20% and 30% of people to freeze and postpone action.

The more choices there are, the more you are likely to put things off.

So by focussing on just two choices you are more likely to get saving and investing.

Making the choices

The first step is to test your appetite and capacity for taking investment risk. Simple investor profiling tools found on investment platforms that offer a robo-adviser, can help you by taking into account your investment horizon, age, income, existing savings, debt and expenses, amongst other factors, to build up a picture of your financial health and how much investment risk you can take on. Read more: What is my risk profile and why does it matter?

Different goals demand different time horizons and exposure to assets, but the right combination of cash and an equity fund will probably meet your needs.

If your investment horizon is short and your appetite for risk minimal, going 100% into cash through a money market option is best. If your investment horizon is longer and you can stomach the risk, you can go 100% into equities by choosing an equity fund.

For investment horizons and risk appetites in between, you can choose any combination in between – 90% money market and 10% equity or 20/80, 60/40, etc.

If you are building an emergency fund, for example, you would invest wholly in the money market fund. Read more: How do I set up an emergency fund?

If you’re young and starting to build a retirement nest egg, skewing the combination towards equities gives you the best chance of growth.

Diversification

Since many investments offer diversification among many asset classes, you may wonder if just two asset classes is enough. Read more: Why should I diversify my investments?

South African money market funds are required to be well-diversified across shorter term investments from different institutions. The rules governing these funds give you, as an investor, significant protection.

If your equity exposure is through an index like the JSE Top 40, an index of the 40 largest companies listed on the exchange, it will offer you further diversification.

The companies in the index cover 18 major sectors, including banking, general industrials, life insurance, retailers, pharmaceuticals, computer services, and real estate.

They also cover the globe, earning significant revenue in regions beyond South Africa like Europe and China.

Some of the shares that are listed on both the local and an international stock exchange (dual-listed), have foreign currency earnings that offer you a hedge against a decline in the value of the rand (a rand-hedge share).

Your exposure may be a bit lopsided

The exposure you get to sectors in the JSE Top 40 may be a bit lopsided – but then that’s true of most indices.

For example, the index’s exposure to resources (metals, mining, coal) was 27% in March 2023.

The index of the top 500 companies listed on stock exchanges in the US, the S&P500, by contrast, has no more than 7% exposure to resources (including energy, a larger component than basic materials).

But it is also lopsided with a 25% exposure to technology shares.

Most indices, in fact, are skewed towards regional heavyweights. The index of the top 100 shares on the London Stock Exchange (LSE), the FTSE 100, is overweight in healthcare shares.

Market changes

You should also remember that the weightings of shares and sectors in indices fluctuate significantly in line with the market capitalisation of the shares and sectors.

For example, five years ago, resources were less than 15% of the JSE Top 40; five years ago energy made up almost 20% of the LSE’s FTSE 100 – more than the JSE's resources exposure in the Top 40. By May this year energy was down to 12.5% of the FTSE 100, illustrating these fluctuations.

Combining funds from either the same or different asset classes can lead to unintended consequences – you, or your adviser, can inadvertently increase the exposures to sectors or shares that already make up a big proportion of the portfolio.

Indices weighted in line with the market capitalisation of the shares give shares with rising prices more of the pie and falling shares less.

This “automatic rebalancing” or bringing the portfolio back into line as share’s market capitalisations change, has provided decent returns over time.

Some investment providers have tried to correct the lopsided exposure with alternative indices, like a Top 40 index that weights each share equally. But they have not outperformed the market indices consistently over time.

Performance

The JSE Top 40 index has provided inflation-beating performance over the last decade, with compound annual growth returns as high as 18% over the last three years.

But you may have heard that US equities have performed better recently – over the past eight years, the S&P500 has beaten almost every other market.

Leading markets change over time - in the eight years to mid-2014, the JSE outperformed the S&P500 in US dollars.

Most ordinary investors do not know when one will be better than another.

If you stick with an index like the JSE Top 40, however, you are unlikely to fare too badly when you consider investments in other markets around the world.

The JSE Top 40 has mostly been ahead of the leading UK stock market index, the FTSE100, in US dollars over the last five years.

Over three years since March 2020 the Top 40 is ahead of both the FTSE100 and an index of global stock markets, the MSCI’s All World index.

Hindsight can make you second guess

Hindsight makes it all too easy to second-guess past decisions. Many investors wish they had been fully invested in the S&P500 over the last decade.

But unfortunately, nobody has a crystal ball and there are many opinions on whether the next eight years will be like the last eight.

The advantages of investing in a local equity index fund is the low cost and that you do not have the bewildering effect of changes in currency values when the rand strengthens or weakens.

The JSE’s Top 40 may not be the ideal equity portfolio, but it offers good geographic spread and good diversification across sectors and currencies.

The huge benefit of focussing on just two simple investment options – like the JSE Top 40 and a money market fund – is that it simplifies the choices you have to make to help you get saving and investing.