You will probably already be aware of the trade-off between risk and return. In a nutshell, the higher the potential return, the higher the risk. Investors seeking high returns (anything above 12% per annum for the sake of argument) may have to face the prospect of high volatility in their portfolio. Investors willing to settle for returns of around 8% can be catered for by less risky assets and are likely to see fewer fluctuations in the value of their holdings. But they won’t have eliminated the risk altogether, unless interest rates rise and bank deposits then pay 8% interest. A bank deposit is considered to be a risk-free asset and it is the combination of risk assets and risk-free assets that forms the basis of efficient portfolio theory, discussed elsewhere on this site.
Generally, the older one gets the more risk-averse the investment strategy becomes, simply because your ability to replenish your asset base in the event of poor performing investments is limited. It is a sad fact that many elderly investors have learned a bitter lesson from the share market collapse of recent years. When you’re younger, you have both the time and the income to top it up – when you’re older and retired you may well not. Time is the crucial factor in this regard.
The level of risk drops dramatically the longer the time horizon you have. Begin investing early enough and you will not have to expose your money to undue levels of risk to achieve your financial goals. And you can plan to have some fun along the way.
As you near retirement, you will move more of your money into cash and fixed interest and reduce your overall exposure to shares and property. Careful planning is required at whatever age, to ensure you have built sufficient growth into your investments so that you have enough to live on and to enjoy a comfortable life however long you live. Cash is good but it won’t last long if you just leave it in the bank.
The need to build growth into your investments is illustrated by the following example. Over the period 1926 to 2000, the returns (after inflation) from the US, the world’s largest financial market averaged;
Stocks 8% per annum
Bonds 3% per annum
Cash 0.8% per annum
These returns are pre-tax. So for an investor paying tax (at 33% say) on income (which means all the return from bonds and cash and the dividends from stocks) but not on capital growth, the post-inflation, post-tax returns in a world where inflation has averaged 3.2% pa inflation would have been.
Stocks 6.6% per annum
Bonds 1.0% per annum
Cash -0.5% per annum
So a portfolio of stocks, bonds & cash in proportions 50/30/20 say would have returned 3.5% pa after tax and after inflation.
This assumes the investor had the appropriate knowledge and discipline to attain market average returns. The fact is that only 30% of investors historically have managed market average or better returns. Even assuming the investor does have these skills, the 3.5% pa does not make any allowance for the cost of the time taken by the investor to run their portfolio.
With so many variables to consider in the process of formulating investments, it is easy to structure an inefficient portfolio based on false assumptions. Patterns of return are not fixed and relying on traditional strategic asset allocation methods may not be appropriate for many investors. The relationships that contribute towards the curve of the efficient frontier are not necessarily constant. Which means some form of judgement is needed.
If you would like to know more, please send me an e-mail.