Every investor is unique, but everyone faces the same trade-off between risk and reward
For the next two weeks we will be tackling the idea of portfolio diversification and what you should know.
The best place to start when you are looking to build a diverse investment portfolio is to ask yourself why you’re building a portfolio. For most of us, the central task is to build a pot of money that involves you, the investor, taking some risk over the long term, at the end of which you will have ideally built up a sizeable portfolio of diversified assets that will last you through to your retirement years.
Some investors don’t have such a long-term objective and are thus less willing to take on risks. They might, for instance, only be saving for ten years to cover school fees. Alternatively, they may already be in retirement and need to generate an income while preserving their money against inflation, even at the cost of future opportunity. For both of these latter groups, a sensible investment strategy is likely to involve a relatively low level of ‘risky’ assets such as equities.
So every investor is unique, but everyone faces the same trade-off between risk and reward. In simple terms, you can’t hope for long-term, above-average returns unless you are willing to take on more risk. This might sound like a simple idea, but an astonishingly large number of investors persist in the myth that double-digit year-on-year growth is possible without risking the loss of a substantial chunk of their assets.
Investing in equities is only a viable option for the long term (at least five years, if not ten), and if capital preservation is your primary objective, you should probably steer clear of stocks and shares, and stick to less risky, less exciting assets such as bonds and cash.
Perceptions of risk
As you grow older and your requirements change (as well as your perceptions of risk), your portfolio of assets must also adapt. To give you an idea of how your portfolio might change, lifecycle or lifestyle funds have been developed. These funds mix equities, bonds and property assets in different proportions according to how close the holders are to retirement (or how far beyond it).
Simply put, they start with 100% of assets in risky equities for a worker in his or her thirties, and then end with a portfolio where 75% is allocated to low-risk bonds for an investor into his or her retirement.
Old rule of thumb
This is known in the investment industry as ‘lifestyling’. It’s a term for a very old rule of thumb: subtract your age from 100, and that’s how much you should hold in equities if appropriate to your particular situation. So if you’re 30, have 70% of your investment portfolio in equities. If you’re 60, have 40% in stocks and shares.
It is vitally important that any rearrangement of your portfolio is controlled and measured. Never forget that every time you buy and sell assets, some of your money is lost in fees. Virtually every analysis of historical returns suggests that investors shouldn’t over-trade, shouldn’t try to time the markets and absolutely should avoid turning into speculators.
Instead, the consensus is that private investors should work out a long-term strategy, build a diversified, robust portfolio, and then sit tight as a buy-and-hold investor.
The basics of building an investment portfolio are surprisingly simple. Work out your own investing style, and then make sure that your diversified mixture of asset classes mirrors your own risk-reward trade off.
Higher risk levels
If you’re willing to embrace higher-risk levels and won’t need the money for a while, think about tilting your portfolio towards shares. If you only have a narrow time horizon for what you want to achieve from your investment, give more weight to bonds and cash.
And don’t get too carried away: keep the underlying funds within your portfolio simple and cheap, and don’t over-trade.