5 Tips to Decrease Risk in your Investment Portfolio
Chris Broome – Chartered Financial Planner
I was asked a question this week by a new prospective client about what strategy Longhurst employs to offer protection against downside market volatility.
A question asked because the other ‘Wealth Managers’ he’s also speaking to were suggesting they’d be using complex strategies including the likes of hedge funds and derivatives.
Our opinion, having lived through events post 2008/09, is that most of these strategies are far too complex and expensive to ever work as intended, with the results often being disappointing and very costly.
The truth is this: Decreasing your investment portfolios volatility doesn’t have to be a complex and expensive endeavour. It also doesn’t have to use strategies which you, the investor, may not truly understand.
You can in actual fact deploy 5 very simple strategies, which once in place will allow you to focus on more important life matters – such as family, friends, travel, or your favourite past time.
Here are our 5 tips to follow:
HOW MUCH IS ENOUGH?
Understand your numbers.
In simple terms:
- What does Financial Independence (FI) mean to you?
- By what age do you want to reach FI?
- Have you already achieved it?
- How much money per year will you need, rising by inflation, to live out your life on your terms?
Once you understand what an ideal life means to you, and How Much is Enough, we can then assess your current asset base, your ability to make further contributions into it (if you’re still working), and how much that asset base would need to grow by each year (through investing) to hit or maintain your FI number.
Once we know how much growth you need, on average, year on year, we can then identify the appropriate asset-allocation mix that your money needs to be invested into. Such as, a 60% equity / 40% bond portfolio.
Once we know the asset-allocation model, and asset weightings, we can then identify the most appropriate underlying funds to then invest into.
Remembering that at all times your investment portfolio’s sole purpose is – to serve your life plan.
The objective of diversification is to maximise returns by investing in different areas that could each react differently to the same world event.
This could be a weighting between Equities (the Great Companies of the World) and Fixed Interest Securities (Government and Corporate debt). It could also include Property, Commodities, and Cash for example.
Although this approach does not guarantee against physical loss, diversification is the most important component of reaching long-term financial goals while minimising risk.
By diversifying your portfolio, you minimise the risk of your investments, as compared to putting all of your money into one asset.
One way to do this is to look for assets that haven’t historically moved in the same direction at the same time. By owning uncorrelated assets that may perform differently over the short run, you increase the chances of achieving slightly higher returns than either of these markets would have achieved on their own.
You also need to ensure you maintain diversification throughout your investment life. You do this by annual rebalancing the portfolio, which is where, once a year, you buy some of the assets that are lagging and sell some of the assets that are outperforming. This manages long-term risk within your portfolio.
Following the 2008 stock market crash, a great deal of investors jumped headfirst into overly complex strategies, including derivative trading, hedge funds, and other magical opportunities that offered absolute returns for investors without the risk associated with the stock market.
Often these strategies are expensive, very hard to understand (do you even know what a derivative is?), and difficult to hold for the long-term. They are also often sold by wealth managers in an attempt to convince the herd of panic-driven investors to part with their hard-earned capital.
The truth is that the simplest way to lower the volatility in your portfolio is to ensure that it in part comprises some Fixed Interest Securities (or debt to you and I).
For example, the S&P 500 was down 56% during the crisis from 2007-2009. A 50/50 portfolio consisting of the S&P 500 and high-quality bonds was down closer to 24% in the same time. But, and it’s a big but, since then the S&P 500 is up roughly 300%, while the 50/50 portfolio is up closer to 150%.
The lesson = Taking on less risk lowers your expected downside volatility BUT ALSO your expected returns. These are the trade-offs you need to consider.
Could you in fact simply ignore the noise that is the financial press, and certain wealth managers, and instead allow your well diversified portfolio (consisting of equities and bonds) to ride out what will prove to be yet another temporary dip in the market place?
Stop focusing on the short term.
It’s that simple.
Successful investors know that short term volatility is temporary. It may last a day. A month. A year. Maybe two. But it is temporary. And once over, the permanent advance of the great capital markets will resume.
Extending your time horizon is one of the most effective strategies an investor can deploy. If you focus on daily returns, it’s basically a coin toss between gains and losses in the stock market, and an increase in your daily stress and anxiety levels. Why put yourself through that?
To be successful you need to extend your time horizons. This will require both discipline and fortitude to hang on in there during the occasional wobbly market moment. But the end results will be worth it.
What is the total cost of the ‘wealth management’ service you are receiving?
Platform cost? Underlying fund cost? Trading costs? Manager cost? Advice costs? Unknown costs?
These costs eat away at your investment portfolio performance day in and day out. The difference in a 0.5%, or 1%, or even a 1.5% charge per annum, can see thousands, if not tens or hundreds of thousands, wiped off your portfolio value over decades.
We counsel all prospective new clients to ask, and truly understand, what the total cost of the ‘recommended’ strategy is?
Whether it’s a well-diversified portfolio of the Great Companies of the World plus some debt; or a complex portfolio of hedge funds and derivatives:
- What is it going to cost you each and every year for the rest of your life?
- And, what growth will that portfolio have to achieve (after both costs and inflation) for your hard-earned capital to have been invested effectively?
- Such that you achieve and then maintain your version of Financial Independence.
Don’t get sold to. Don’t follow the herd. Keep things simple. Remain diversified. Manage cost.
You’ve then got a fighting chance of becoming a successful investor.
THE VALUE OF INVESTMENTS AND THE INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.