What to do when rates go hayway
SEAN is a diligent schoolteacher who loves his job. He spends most of his time at his workplace, teaching physics. For many years now, Sean has been teaching Isaac Newton’s Laws of Motion. One of the laws states that: “Every action has an equal and opposite reaction”.
Sean has seen this law playing out even in the Zimbabwean economy. The point here is that Sean earns ZW$20 000 (US$238 at official rate) every month and pays his rentals in United States dollars at a rate of US$80 per month.
He has been working with an exchange rate of US$1 to ZW$100 (parallel market rate) for some time now. This means that his rental costs per month had been 80×100 which equals ZW$8 000. That said, some form of action occurred on the foreign exchange market in Zimbabwe recently and caused the exchange rates to move to ZWL120. The reaction was that Sean’s income was affected. In fact, his new rental bill would be 80×120, which equals ZW$9 600, representing a ZW$1 600 increase.
Sean’s story demonstrates how household incomes in Zimbabwe are so vulnerable to shocks such as exchange rate movements. The underlying fact is that Sean earns in ZWL whilst his major monthly bill (rent) is in USD and this exposes Sean’s income to exchange rate shocks.
Piggy has always advocated for individuals and households to invest as a value preservation strategy. Such an approach to Sean’s personal finances will not only preserve value but also hedge against shocks given that his income stream is exposed to adverse foreign exchange movements.
Money versus stock market
Some folks have asked Piggy whether to start off by investing on the money or stock market. The fact is that these are two asset classes with different characteristics. A money market instrument is characterised by fixed income instruments.
The risk associated with money market instruments such as Treasury Bills is low and income is provided in the form of interest. When the income is reinvested, it will lead to an increase in capital value. Also linked to the money market are bonds that are medium to long-term investment instruments. Bonds offer a guaranteed stream of interest income and capital growth is possible if the price of the bond strengthens, which will potentially happen when interest rates drop. The risk associated with bonds is medium.
On the other hand, the stock or equities market involves the investment in shares which are long term investment instruments.
Shares or stocks tend to provide better potential for capital growth than cash and bonds over the long term. Income is derived from dividends while it also depends on an increase in the price of the share, which of course is also not guaranteed. This is what makes an investment in equities a medium to high-risk investment.
Classification of markets
The decision on whether to invest on the money market or stock market lies in the specific investment objectives as well as risk profile of the investor. It is generally recommended to invest short term funds on the Money Market whilst long term money can be directed to the Stock Market. All in all, the differences in characteristics is to the advantage of an investor given that there is scope to include all asset classes in a single portfolio thereby helping in terms of diversification and risk management.
Ways for diversifying
Diversification is one of the most important aspects when it comes to minimising risk within an investment portfolio. The rationale is that a portfolio constructed of different kinds of investments poses a lower risk than any individual investment within the portfolio. Diversification therefore helps to mitigate the unpredictability and volatility of markets for investors.
By increasing the number of securities in a portfolio, one can achieve higher Sharpe ratios. Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities yields further diversification benefits, albeit at a smaller rate. The following are some of the ways retail investors can diversify their investment portfolios;
•
Diversification across asset classes. Investors should always consider their investment mix and look to diversify across different asset classes such as property (REITs), stocks, bonds, cash, mutual funds and other alternative investments. The asset mix can also be structured in line with investor needs and objectives. For example, if an individual is looking to retire soon or if they may be in need of cash, bonds and short-term investments may be appropriate;
•
Diversification within each asset class. Investors must always be wary of overconcentration in a single stock or asset. It may not be advisable to have a single stock constituting more than 5% of your stock portfolio;
•
Sector diversification — securities within the portfolio should vary by industry.
A key question that retail investors ask is how many stocks they should buy to reduce the risk of their portfolio. According to portfolio theory, after 10-12 stocks, you will move towards optimal diversification.
•
However, the 12 need to be diversified across sectors/industries. In the case of the Zimbabwe Stock Exchange (ZSE), an investor can invest in various sectors such as food producers, retail, telecoms, forestry and paper, life assurance, technology, pharmaceuticals and packaging;
•
Diversifying stocks by market capitalisation — another way is to diversify stock holdings by investing in small, mid, and large caps companies;
•
Diversifying the styles — investing in different themes such as growth and value could also bring a balance within a portfolio;
•
Diversifying through management — the Fund of Funds concept is based on the need to diversify by bringing in different management strategies within a portfolio. In a similar manner, retail investors can also allocate some funds to external managers; and
•
Geographical diversification — an economic downturn in Zimbabwe may not affect Kenya's economy in the same way; therefore, having investments on the Nairobi Stock Exchange gives an investor a small cushion of protection against losses due to a downturn in Zimbabwe.
Enter ETFs
One important aspect Piggy has noted is that most non-institutional investors have a limited investment budget and may find it difficult to create an adequately diversified portfolio. Low-cost Exchange Traded Funds (ETFs) provide a platform for investors to gain exposure in global indices, commodities and track local indices. The Securities and Exchange Commission of Zimbabwe (SECZ) recently hosted a webinar on ETFs to create awareness on the existence of the ETFs and to educate investors and the public about the product. This was the first in a series on webinars on ETFs. An ETF is a passively managed open-ended fund that tracks performance of an underlying asset. The underlying asset can include but not limited to indices, currencies, commodities, amongst others. A recording of the Webinar is available on the Securities and Exchange Commission of Zimbabwe Facebook page (https://www.facebook.com/ 537848949637029/ videos/461841595002102)
In conclusion, the investment mix or asset allocation that is chosen by an investor should always be aligned to one’s investment time frame, financial needs and comfort with volatility.
Matsika is the head of research at Morgan & Co and founder of piggybankadvisor.com. — batanai@morganzim.com / batanai@piggybankadvisor.com or mobile: +263 783 584 745.