It’s always been human nature for people to want what they can’t have. And in the investment world that can often be summed up by wanting all of the upside with none of the pain. Is this possible? Maybe not. But by adopting a structured, risk-managed approach to investing, would you be happy to eradicate most of the pain but still see a rate of return ahead of inflation during the up times? If your answer is ‘Yes’, read on…
If you’ve been reading my column over the past few months, you’ll know my thoughts on what is needed to lay the foundations of a robust financial plan – pay off your debt, build up a sustainable level of liquid emergency funds, put in place sufficient safety nets aligned to your personal situation and write your will. Once all these boxes are ticked, we can move forward and start creating a pot of wealth that provides the financial peace of mind and security we all desire.
Just as the ‘putting all your eggs into one basket’ analogy preaches, this peace of mind won’t be found by picking winners – predicting that the price of gold is going to bounce back in the next 12 months or picking a single equity such as Apple and hoping its share price will be back to the heady heights of over 700 this time next week is not the answer. Placing your eggs in different baskets is what I’m talking about. Let me explain…
There are 18 asset classes out there, within which you can invest your money. These range from cash and fixed interest at the more cautious end of the spectrum, all the way up to commercial property, precious metals, commodities and equity-based investments, which are spread far and wide across every continent. So which asset class will come out on top during the second half of 2013? Which asset class will achieve the best returns throughout the whole of next year? Whatever anybody tells you, however passionate their argument is, nobody knows – and that’s a fact.
I don’t want to get too technical here, but back in the late Eighties, a Seattle-born money manager by the name of Gary Brinson dedicated much of his time to studying this in detail. He summarised his findings by suggesting more than 91.5 per cent of a portfolio’s return can be attributed to its mix of asset classes – not just by picking one or two asset classes and hoping to get lucky.
In Brinson’s study, individual stock selection and market timing accounted for less than 7 per cent of a diversified portfolio’s return. Put simply, a little bit of everything aligned to an individual’s appetite for risk is the way to go.
Let’s bring things back to real life a little, but firstly we need to ask a question: what are the chances that in any given year, all 18 asset classes will see a positive return? The last time this happened was in 2005, so it’s a rare occurrence. A more realistic question may be: what are the chances that over a five- or ten-year period, more of these asset classes will go up rather than go down? ‘Very likely’ would be the answer, certainly over the medium to long term.
OK, so now I want you to imagine you are on holiday. I’m going to use the example of the British seaside – warm and sunny one minute, the next thing you know the heavens have opened and you’re running for cover. Visualise a vendor plying his trade along the beachfront. He’s a wise old soul, and rather than just selling ice creams, he’s done his homework and has a selection of umbrellas ready to sell when the weather turns.
He’s taken a diversified approach and adopted the clever ploy of selling two products that are negatively correlated. He’s happy – he should be able to make a decent living whatever nature decides to do on any given day.
Working with a financial professional and constructing a robust investment portfolio doesn’t have to be as daunting as many people would have you believe. If you go for the red-or-black roulette approach of picking just one asset class, then guess what, you’ll fall flat on your face before you know it.
By adopting the structured approach I’ve illustrated above, keeping a regular eye on your appetite for risk and reviewing your portfolio regularly, you’ll be able to sleep easy come the end of the day. And that is a fact.
Right, I’m off for an ice cream now, but I’m taking my brolly with me, just in case!