Investments: Spread the risk to maximise returns

Investments: Spread the risk to maximise returns
Getting the balance right could make the difference between a winning and a losing portfolio.

By Paul Farrow
Last Updated: 4:52PM GMT 13 Mar 2009

You will often have heard investment professionals talk about the need to build a balanced portfolio spread across a variety of asset classes.

It is, therefore, perhaps surprising that research reveals that many private investors know next to nothing about asset allocation when it comes to building their investment portfolio.

Research has shown that nearly four out of 10 investors admit that they have little idea how their portfolio is split between equities, bonds and cash.

Even fewer investors are aware of the split in their portfolio by geography, sector or size of stock. Half of those polled confessed that they did not know how their portfolio was structured by country, while 49pc admitted to a similar ignorance about sector exposure, and 48pc were not sure how the portfolio was split between large, mid and small-cap stocks.

Put simply, asset allocation is the balance between the major asset types of property, cash, fixed interest and equities in an investment portfolio.

Getting the balance right is vital if you want to achieve your financial objectives. Fail to do so and it is easy for you either to buy the wrong kind of investment or to create a portfolio of investments that is unlikely to generate the desired results.

The stock market turmoil between 2000 and 2003 showed just how important it is to have a balanced portfolio. People whose portfolios were heavily exposed to equities suffered disproportionately large losses as share prices plummeted.

On the other hand, those with balanced portfolios that had decent exposure to fixed-interest investments such as corporate bonds, property and cash would have fared a lot better. The three asset classes produced positive returns as share values fell, which would have helped offset the stock market losses and eased the pain.

In recent years it has been harder to call – most assets have fallen in value. Overexposure to assets such as emerging markets and commercial property would have hurt you more than exposure to safer investments such as cash and gold.

In real life, the eventual mix of assets in your portfolio will depend on your own personal circumstances, such as your age, earnings, attitude to risk and financial objectives. People with more substantial portfolios, for example, are sometimes advised to introduce more sophisticated investments such as hedge funds and structured products into the mix.

Building a portfolio is also a question of managing risk versus return.

Risk is not just about potential capital losses – you also have to consider the risk of inflation and a potential reduction in income if circumstances go against you. For example, people in their thirties and forties may be prepared to have a greater exposure to equities because they can afford to take a longer-term view and will be looking to grow their portfolio.

People who are nearer to retirement are more likely to want to preserve the capital they have got and adopt a more cautious strategy, with a bigger exposure to corporate bonds. The sensible investor takes into account the amount of risk they are able to tolerate, both psychologically and in terms of their individual needs.

It is therefore vital to understand the different levels of risk inherent in various types of investment. Overly concentrating on a single asset class will increase the risk to a portfolio unnecessarily.

Investors have traditionally adopted a pyramid strategy for building a portfolio, starting with cash, then fixed interest, with equities at the peak. The consensus is that you start with a solid foundation of cash before dabbling in equities or bonds – some say a cash nest egg should represent three, or even six, months' salary.

It is difficult to generalise as individual circumstances will be different, but broadly speaking many experts agree that people seeking medium to low-risk capital growth should aim to have a portfolio that is 60pc invested in equities, 25pc in bonds and 15pc in cash. Those seeking a high, regular income, on the other hand, would do better with just 20pc in shares, 20pc in cash and the remaining 60pc in bonds.

As mentioned earlier, the balance of assets will depend on factors such as age, attitude to risk, financial objectives and the length of time over which you intend to invest.

For example, equities should be viewed as long-term investments – that is to say, held for at least five years. If you cannot afford to wait for that long, you should concentrate on lower-risk, fixed-rate investments such as bonds. If you are looking at less than three years, you should probably limit yourself to cash-based investments.

In the past, as people grew older their investment portfolios became risk averse. They reduced their exposure to equities and generally avoided investments that put their capital at risk. But times are changing and this may not be the right strategy to adopt.

In real life, it is not just the asset mix that investors need to consider when building a portfolio. There are also tax implications, be it capital gains, inheritance tax or income tax liabilities.

For example, it is prudent to make sure you are not handing over more money to the taxman than you need. Individual savings accounts (Isas) allow you to invest up to £7,200 each financial year and gains are free from capital gains tax.

The tax credit on dividend income has recently been scrapped, which means basic-rate taxpayers get no income tax benefit with Isas, but higher-rate taxpayers still do. This is because they will still get a net dividend payment worth 25pc more than they would if their investments were outside an Isa and they had to pay tax.

Obvious practicalities dictate that our Fantasy Fund Manager game will be played over the short period of less than a year, rather than a decent real life investment horizon of five years. Many investors are buying corporate bond funds and equity income funds – whether they will be the winners come next year, who knows.

The shrewd professionals are usually ahead of the game – they take profits before the price has peaked and often buy before values have bottomed.

http://www.telegraph.co.uk/finance/personalfinance/investing/4984569/Investments-Spread-the-risk-to-maximise-returns.html