In Part 1 we looked at the impact of time and quantum in building savings and investments to best equip you for life’s journey and to ensure you combine liquidity (having access to your money when you need it) with returns in excess of inflation, to ensure you maintain buying power. A brief reminder; keep your short-term money on deposit and use an evidence-based investment process with your longer term money. Simple, eh! In Part 2 we are looking at how to best use capital markets to give you the returns you need to maximise the chance of living life as you want to, at a level of risk that will not keep you awake at night.
If there’s one thing to take away from this it is to understand that risk and return are related. In other words, provided you stay diversified and disciplined, the more risk you take the greater the rewards should be.
What do we mean by this?
Despite there being tens of thousands of ‘ways to invest’ out there, life doesn’t have to be that complicated and you can get the returns you need by predominantly mixing the two broad asset classes: equities (shares) and bonds (debt issued by governments and corporations). In short, on average and over time equities should produce greater returns than bonds and bonds should produce greater returns than cash. However, both asset classes do fluctuate and in the short-term (yes, it’s that time thing again) the value of your ‘long-term’ money can (and will) fall. Also, equities are more volatile than bonds and bonds are more volatile than cash. See what’s happening here?
So a portfolio invested 100% in a collection of equities is likely to provide a greater long-term return, but it is absolutely certain to put you through uneasy periods where an unpredictable market can cause emotional unrest. A portfolio invested 100% in a portfolio of bonds will allow you to sleep easier, but over the longer term will not provide the higher returns. The numbers below help demonstrate this short-term volatility against longer term returns by comparing annualised returns against best year and worst year performance.
|Annualised Return (%)||5.2||6.6||7.8||8.9||9.9||10.7|
|Lowest One-Year Return (%)||0.4||-4.3||-12.7||-21.4||29.9||-38.3|
|Highest One-Year Return (%)||15.9||19.8||27.3||39.0||51.6||65.2|
For most investors, combining equities and bonds, rather than opting for either one or the other, helps spread the risk whilst maximising returns in relation to the risk you are prepared to accept. In short, a portfolio with an 80/20 equity/bond mix should produce returns greater than a 60/40 equity/bond mix etc., but with greater short-term volatility.
How do I know how to mix the asset classes?
Due to a combination of factors involved in answering this question, every case is different. Although there are some general rules that can apply to us all:
- What returns do you actually need? Some investors will never run out of money as they may have more income than they spend alongside a significant capital sum, whilst others may need unattainably high rates of return if they are to do all the things they want to do.
- How much short-term pain can you tolerate and stay disciplined? Discipline is the crux of the issue, more of which below…
- Time; you already know this! A 25 year old investing in his or her pension fund can benefit more from time in the market than an 80 year old. The longer the time period, the greater the chance of added risk producing higher returns.
How can we measure your risk tolerance?
There are a number of tests available to help your financial planner (and you) understand your ‘snapping point’ in terms of short-term volatility and these tools help as a guide when establishing the most appropriate asset allocation (i.e. the mix of equities and bonds). It is also important that all investors get their heads around the reality of what can happen in investment markets and just how much volatility there can be. After the last few years of pretty benign and generally upward movement of markets, it’s easy to forget the meltdown of 10 years ago, the global financial crisis and just how worrying serious downturns can be. Serious downturns will always happen and we will never know when, in advance.
Once your asset allocation is agreed and established, the whole thing will only work if you stay in the seat and ignore the noise, accept the volatility and keep calm in the face of a full-blown media onslaught and doomsday predictions. The risk ‘tests’ referred to above must be stress tested and as an investor you need to be completely comfortable with all likely outcomes. For example, questions such as “over the past 30 years the worst year of returns in this portfolio is -25%. How would you feel if this happened and would you have the guts to stay invested?”. These questions are vital in helping us to help you through the maze and understand the implications of risk.
In other words, investor behaviour is the single biggest risk in getting the returns that markets will highly likely give, if they are given chance. This inevitably involves ignoring everything you see, read and hear from so called ‘professionals’. You need to be different. You need to accept that bad things happen, but that over time a greater number of good things will happen and that you should win and never drift off course. Discipline, discipline, discipline.
So we have an asset allocation, what next?
Once we know the returns you need, your tolerance of risk and capacity for loss we can then start to look at how your portfolio is constructed. For example say 60/40 equities/bonds and a portfolio of £400,000.
Taking an extreme example, you could invest 60% in a single share and 40% in a single bond (for example, £240,000 invested in Tesco shares and £160,000 in Italian Government bonds).
Lesson one here is diversification and to spread each asset class across a huge number of different shares and bonds to spread this risk. You can also diversify further, by investing globally rather than sticking to the UK and mix the sectors and types of company you invest in.
So, who then decides what shares and what bonds to buy? Investment advisers are broadly divided into two camps; in one camp are the stockbrokers/active fund management community who believe that they can ‘predict markets’ and ‘pick the winners’, and in the other camp are those that base their investment policy on decades of evidence of how markets work and where returns come from.
The third and final part of this series will cover the argument between evidence-based and speculative investing and where Manse Capital sit in this debate.
Financial Planner & Director