Investing: risk and reward
Investing means holding capital with a view to seeking returns such that your money still has its original ‘real’ value when you access it. We achieve this by using various assets such as shares, fixed income securities and property funds.
Time does much of the work so this needs to be money that you can afford to ‘tie up’ for at least 5 years and, ideally, longer. Investing should always be to meet your own longer term goals. Money for short term events such as holidays, changing your car and improving your home, plus some emergency cash, should always be held in savings accounts so that investments don’t need to be accessed at short notice. This is because, although we expect to achieve returns above inflation and cash returns over the longer term, in individual years the value of investments can – and do – fall. Risk and reward go together and it’s important for the balance to be right for you.
We don’t want you to have to withdraw your capital when markets are unfavourable.
Before assessing the suitability of investment for you we need to establish:
- your current financial and life situation, health and family circumstances
- your future plans
- your timescales
- your tolerance for, capacity for, and need to take, investment risk
- how much accessible cash you should retain
Investment Risk
Risk and reward go hand in hand and you must be comfortable with the level of fluctuation in capital values that might occur on your portfolio. We use various tools to assess and measure your risk tolerance and we will talk about it with you so that you appreciate the range of possible outcomes from your portfolio over time. We also consider your capacity to take risk and your need to take risk.
Risk has four primary aspects that are discussed when we sit down with you:
Risk perception generally relates to how much you know about investment markets and their tendency to follow a roller-coaster path that is not always comfortable to endure. We tend to be more afraid of things that we know very little about. Those who have a high degree of knowledge about financial markets tend to see them as less risky.
Risk tolerance expresses how you feel emotionally about taking risk. Where do you strike the balance between getting a favourable outcome versus and unfavourable outcome? Analysis suggests risk tolerance slowly decreases with age, and personality traits are known to be affected by major life events, good or bad. However, it appears that risk tolerance neither collapses in bear markets nor soars in bull markets. We see that people tend to accept risk in bull markets and avoid risk in bear markets. What we are talking about here is often linked to misunderstandings about how markets work in the long term. We use a risk profiling tool called ‘Finametrica’ that has been long established as a credible measure of how we instinctively feel about risk.
Risk required is often overlooked and relates to the returns that you need to meet your objectives. The higher the return required the more risk might have to be taken, and this need may override your perception and tolerance. Keeping your capital in cash will reduce purchasing power over time in an inflationary world. On the other hand, you may choose to amend your future plans in line with your attitudes.
Risk capacity has to do with whether, for a given level of risk, your financial situation can withstand the impact of a market decline without suffering an unacceptable loss of lifestyle now or in the future. Keeping a good cash buffer is how most of our clients deal with market volatility.
Asset Allocation
We believe that the most important investment decision relates to the mix and proportion of equities (shares), fixed income securities (government and corporate bonds), cash, commercial property and other assets that will be held in your portfolio. Academic research suggests that this process, called ‘asset allocation’ is the key to successful investing and that stock picking and trying to time the market are much less relevant in the longer run, and indeed can be detrimental to your wealth.
For us, the most important decision concerns the mix of holdings in the portfolio rather than focusing on the individual holdings themselves. To work out what is best for you we consider factors such as your financial needs and objectives, your overall resources, your attitudes to risk, capacity for risk and for how long you want/need to invest.
When constructing investment portfolios we follow the principles of modern portfolio theory (MPT). This was first developed in the 1950s by Harry Markowitz. The aim is to maximise return and minimise risk over the long term by carefully choosing different assets and blending them in a portfolio.
MPT is a mathematical formulation of the concept of diversification in investing; selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible in theory because different types of assets often change in value in opposite ways. For example, when the prices in the stock market fall, the prices in the fixed income (bond) market often increase, and vice versa. A collection of both types of assets can therefore have lower overall risk than either individually.
In the short term, external events can impact on investor behaviour and market efficiency making them act and react in unpredictable ways. This is why we view investing as being for periods of not less than five years and preferably much longer. We avoid ‘knee jerk’ reactions to short term rises and falls in equity markets. To defend against this volatility we usually advocate high cash holdings outside our clients’ investment portfolios to give liquidity and the capacity to ride out market highs and lows.
Our Investment Philosophy
There have been major changes to the state pension recently, somewhat controversially. Now, a flat rate will be paid to all those who have 35 ‘qualifying years’ at state pension age. State pension age is currently from ages 66 to 68. It’s a good idea to check your own entitlement well ahead of retirement to give time to boost the state pension if appropriate. It can be very cost effective to buy additional state pension, and we can advise on the options and the timing.
Passive Investment
Active fund managers continually buy and sell their holdings to meet their investment objectives. This ‘portfolio turnover’ can be significant with corresponding costs that eat into your returns. We use low charging funds that follow indices as well as similar funds that have mechanisms to focus on particular market elements thereby retaining the potential to outperform the main markets. The buying and selling of shares is minimal.
We build our client portfolios to suit individual risk profiles and investment objectives by choosing from the growing number of passive and ‘enhanced index tracker’ type funds. By removing the workload of an active fund manager we can save management costs.
These types of fund offer:
Diversification – they can be an ideal way to achieve diversification, as they hold all (or a representative sample) of the securities in the target benchmarks.
Tilt – an enhanced tracker fund allows us to ’tilt’ portfolios to include funds with an increased exposure to smaller, value, and profitable companies. Evidence shows that superior returns can be achieved from such funds over time as long as you are willing to accept increased volatility.
Low costs – as index funds track a target benchmark they generally have lower advisory fees, operating expenses and trading costs than actively managed funds.
Ease of understanding – the funds have precise objectives – to track various indices – and the charges are clearly expressed with no extra costs hidden in small print.
You should remember that index and passive funds don’t lower overall market risk. When the stock market falls, the price of shares in an index fund falls too.