Deciding where and how to invest is a big challenge. But if the very idea of risk makes you nervous, remember Sir James Goldsmith’s remark: “The ultimate risk is not taking a risk.”
The real art of designing a portfolio (a set of investments designed to meet specific requirements) is balancing the desire for growth or income with the possible risk of loss.
Can house prices be scary?
Most people think of the stock market as risky because they can see prices going up and down on a daily basis. Try a thought experiment: suppose that at the end of your street there was an electronic display that showed you the value of your and your neighbours’ homes. These values too would fluctuate by the day, the week and the month. Do you think you would be happier as a result?
Almost certainly not. Seeing the huge amounts of money at stake from weekly and monthly fluctuations would probably make you more nervous, especially when all the commentators were predicting a fall in prices.
Actually NOT having this level of information about the value of your home makes you more content (you don’t look in local estate agents’ windows when prices are falling, do you?) and contributes to your feeling that it is a good investment.
Work out a way to deal with market moves
The knowledge factor is one reason why people buy poor-value packaged investment products that tie their money up for years - because they won’t have to look at them or think about their value.
A more mature attitude is to recognise that price fluctuations in themselves are rarely a valid source of anxiety and to try to work out a method of dealing with the effects of these fluctuations.
Do this, create your own portfolio and you should get better returns than you can with packaged products (partly because you’ll pay less in charges) and have more control over your capital, which means you’ll be better able to deal with changes in your circumstances and needs.
Identify the risks
The starting point is to recognize what risk is and where it comes from. Let’s assume you want to have a sum of £15,000 available in ten years’ time. How much risk is involved depends on how much you have today.
If you have £10,000 to invest today, you need to get an annual return of only 4.1% over the next ten years to end up with £15,000 and a rate of 4.1% is available from many fixed-rate investments that guarantee you will end up with the £15,000 you need. Job done?
Maybe not. When you said you wanted £15,000, you probably meant in terms of today’s spending power. So what about inflation? The risk of inflation is open-ended because we don’t know what will happen in future. But we can be pretty sure there will be some inflation.
Account for inflation
At the moment, a reasonable assumption might be inflation at 2% a year, which means that in ten years’ time you will need £18,300 to buy what £15,000 buys today.
So perhaps £18,000 should be your target. In that case, you need to get an annual return of 5.9% on your £10,000 to end up with the sum you want. And there aren’t any investments that will guarantee that rate of return.
If you started with less than £10,000 but still needed £18,000 in ten years’ time, you would need to achieve an even higher rate of return and would need to put more of your capital into investments carrying some risk of loss.
More time cuts the risk of loss
Now you face the dilemma all investors confront. In order to get the money you want in the future you have expose some of it to the risk of loss over the next ten years. But in fact it isn’t that bad.
If you hold for a full ten years, the chance of losing money in UK shares is under 8% (over about 1 in 14 of the consecutive 10-year periods since 1900, shares have ended up at a lower real value after taking inflation into account). So, if you need £18,000 in ten years and put some of your £10,000 into shares now, you are very likely to hit your target.
In the meantime, though, prices on the market will rise and fall, in what often seems a random fashion. In fact, as far as anyone can tell, it is a random fashion, which is why most price movements do not in fact contain any important messages like ‘Panic! Sell!’ Over most periods of ten years or more in the stock market, a Rip Van Winkle strategy has worked extremely well: go to sleep and wake up richer.
Review regularly but not too often
But - and there has to be a but - there are changes in the market, reflecting changes in business, government policies, inflation, interest rates and so forth. And it can and sometimes does make sense to make changes to your investments in response to them.
So the slightly more difficult blueprint for a good investment strategy is: create a set of investments that on past form should achieve what you want without too much risk, review regularly but not too often (every 6 or 12 months) and make changes only when there are really good reasons for doing so.
Deciding where the money should go
The most important task in designing a portfolio of investments is to decide how much money goes into each asset class - in the jargon, this is the ‘asset allocation decision’.
An asset class is a set of investments with common characteristics that can all be expected to behave in the same way in response to specific events or economic developments.
The commonly agreed easy to purchase asset classes are: cash deposits; fixed rate investments; commercial property; residential property; shares.
Risk and return
We have a lot of historical evidence about the returns each of the major asset types has generated over periods of up to 100 years (see table), and the same data also tells us about typical volatility - the variations in price that we can expect.
Since the future is unpredictable, and we don’t know when downturns will come, this means that someone needing to draw on their capital within a few years takes on a lot of risk if they invest a high proportion of their capital in shares. But it also shows that over the very long term, you will almost certainly get a higher return from shares than from other assets even if they fall sharply in price just before you cash in.
How investment types have performed over the long term
| Type of asset | 10 years | 20 years | 50 years |
| Cash deposits | 2.9% | 4.1% | 2.0% |
| Fixed rate investments | 5.6% | 6.2% | 2.1% |
| Shares | 5.0% | 7.4% | 6.6% |
Source: Barclays Equity-Gilt Study 2006 - All figures are real returns (after adjusting for inflation) and before tax
The longer the planned term of your investment, the more likely it is that the more volatile asset classes will generate the highest returns. That is why they form the largest component of our Long-Term Growth Portfolio.
With its 15-year timescale, it has 70% in shares, 20% in property and just 10% in fixed-rate investments. But the Short-Term Growth Portfolio not only has a smaller proportion of capital invested in shares, it contains share-investing funds with less risky strategies than those in the Long-Term Growth Portfolio.
| Portfolio | Intended term | Cash | Fixed interest | Commercial property | Shares |
| Short term growth | Five years | 10% | 15% | 20% | 55% |
| Medium term growth | 10 years | 0% | 10% | 15% | 75% |
| Long term growth | 15 years | 0% | 10% | 20% | 70% |
| Income | 10 years+ | 10% | 40% | 15% | 35% |
Two steps to a better portfolio
So there are two ways of adjusting the risk-return balance. One is the division of capital between the asset classes: the more capital in fixed interest, the less risk of loss at any point in time; the more in shares, the greater the risk of loss.
The other is the selection of investments within the asset class. Choose funds investing in blue chip shares that pay high dividends and your risks of loss are relatively low; buy shares in small blue-sky technology companies and your risk is enormous.
In our Model Portfolios we combine both methods to produce balanced portfolios within their stated objectives. But since portfolio design is an art and not a science, there are no guarantees about their performance.
Use our best buy funds where you can
In our Model Portfolios, we do not include residential property, because most investors already have a substantial investment in this asset class in the form of their own home. But we do include commercial property (shops, offices and industrial property) because this asset class behaves quite differently from residential property.
You may choose to manage some of your own money in shares instead of using collective funds. But in our view you would be daft to try to select Japanese shares yourself. For overseas markets, and for many other asset classes such as commercial property, collective funds are the best solution. Wherever possible we use funds already selected for our Best Buy tables in these portfolios.
The golden rule
The golden rule in investment planning is: Invest for the rest of your expected time on the planet, taking account of any specific needs for future cash withdrawals from your investments.
Take account of the past and use long-term historic averages as guide to what to expect, but try to make sensible judgments about the future that do not simply assume a continuation of current trends.
Our Model Portfolios are simply guides to implementing this principle - investment planning is an art, not a science - and will need adapting to your own specific circumstances and especially your own expected future needs for cash withdrawals.
Important Notice and Risk Warning
The EveryInvestor Model Portfolios are for general guidance only and do not constitute a recommendation for any investor. EveryInvestor does not provide individual investment advice.
Your own personal circumstances and tax position must be taken into account in selecting investments. We recommend that you obtain advice from an independent financial adviser before making investment decisions.
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance.
