DESPITE what my grandchildren think, I am not a square, at least not when it comes to deciding on the structure of my investment holdings. Nor should you be. Allow me to explain.
We are living longer and, for many, the impact of the financial responsibility, in whole or in part, of caring for elderly parents as well as adult children who still need financial help to get on the property ladder, means that, over the longer term, there are additional crucial demands on our wealth. That’s before you can fully enjoy your own retirement financially.
Most investors I meet are aware that a well diversified holding of assets is more likely to protect their wealth over the longer term. There is a growing awareness that, although cash in the bank is necessary for money that you’ll need in the short term, beyond that its value is eroded by inflation over the medium to longer term.
However, investing only in equities can be a high-risk strategy because, although over the long term they have proved to provide returns in excess of inflation, they are volatile and inappropriate for investors who may have shorter-term needs for access to capital.
The way to build a diversified portfolio of assets is to start by establishing the basics:
- Your level of risk tolerance
- Your personal investment objectives
- Your investment time horizons
- Other assets owned by you that should be considered in terms of their place and risk impact on the overall portfolio.
With this information, and working together with you, your adviser can construct an appropriate portfolio. It is vital that you understand each component of the portfolio and why it has been recommended.
Each individual client portfolio must reflect its owner’s uniqueness and different needs. It is an established process to view the portfolio building technique as the building of a pyramid. Larger amounts, normally allocated to lower-risk assets, will usually form the foundation or base of the pyramid, with smaller amounts being allocated to the higher-risk assets at the top of the pyramid.
The importance of the pyramid principle is to ensure that the portfolio is not over-exposed to any particular area. It is used as a technique to help reduce the overall volatility of the portfolio.
The specific investment recommendations you receive from your adviser may not in themselves represent a pyramid structure; however, once any other assets you already own are included, the overall approach should do so.
For example, if you are looking for long-term growth and are prepared to accept some volatility in the short to medium term, you may have a pyramid that looks something like this:
- 20-30 per cent equity funds at the top
- 30-35 per cent property funds
- 40-45 per cent fixed interest and other bond funds at the base
It must be remembered, however, that each portfolio recommendation should be based specifically on the core fundamentals of your risk tolerance, investment objectives, timeframe and other existing assets.
If you are looking for income from your portfolio, this is typically generated from the fixed interest or other bond and property elements, while the equity component will seek to provide longer-term growth outperforming inflation, possibly for the whole portfolio.
Once the investment strategy and subsequent portfolio has been established, it is important regularly to review all aspects. Ask yourself:
- Has your attitude to risk altered?
- Have your investment objectives changed?
- Are your investment time horizons still the same?
- Have your other assets held outside of the portfolio been varied?
- Have any of your personal circumstances changed?
Any changes to the above factors may require the pyramid structure to be varied and the portfolio to be amended.
As each portfolio will be constructed with different asset types, which carry different levels of risk and growth expectations, over time it is possible that the higher-risk and higher-growth components of the portfolio will grow faster than the lower-growth assets at the bottom of the pyramid. Hence the shape of the pyramid is likely to change, becoming more similar to a square, where there are equal amounts invested in high-risk assets as there are in lower-risk assets. In extreme cases, as a result of growth, it is possible that the pyramid becomes inverted to the extent that there are more in higher-risk assets than in lower-risk ones.
Clearly, any change of this nature will alter the risk profile of the whole portfolio and it is therefore important that each portfolio maintains a consistent approach with the attitude to risk and objectives of each client. As investment values change within the portfolio, adjustments should be carried out to maintain the pyramid principle suited to your requirements.
Risk is not constant. Conventional wisdom would say that cash is a low-risk investment. However, the risk attached to cash differs based on whether you are planning to hold it for the short term or the longer term, and whether you will withdraw the interest to spend.
So, if you are holding it for the short term, then it is arguably low-risk; if you are holding it for the longer term, it becomes higher risk due to inflation and other possible investment choices, and even higher if you regularly withdraw the interest.
Assets such as equities have a reverse profile, in that the longer you hold them, the lower the risk. Equally, the higher equity prices rise, the more likely the risk of a short-term decline.
Rebalancing portfolios on a periodic basis might reduce exposure to assets that have performed well above expectations – and therefore where the risk to those assets has increased – and reallocate it into assets that are considered lower risk to try to secure profits earned while maintaining the personal pyramid format.
This approach will lower the overall risk to the portfolio over time and can also assist in providing less volatile, more consistent returns.
This column is written by Bill Blevins of Blevins Franks financial advice group (www.blevinsfranks.com), who has written for the Sunday Times on overseas finance for the past 10 years. He is the
co-author of the Blevins Franks Guide to Living in France. This column is exclusive to Connexion.
