Retail Bonds in a Balanced Portfolio

Portfolio

Retail Bonds in a Balanced Portfolio

Those wishing to achieve a better rate of return from their money than they could get from a bank account and seeking to take more control of their financial future, could consider building their own investment portfolio.

Whilst many options exist in terms of ways to invest and account types that are available, and these will be explored elsewhere on this site, the key to a successful (profitable) strategy is the establishment of a balanced investment portfolio.

However daunting it may sound, an investment portfolio is simply where you keep your money. If all your money is held as cash in your bank account, that’s your portfolio.

Mr Bond says... "Bonds are safer. You buy debt, for example debt issued by a government (sovereign debt), and the company or country pays you back over a set period (hence fixed income) so that you get back more than you put in."

But it’s not a smart investment portfolio – the interest you earn on your savings will probably be below the inflation rate, so the value of your money will decrease over time. For example, if your current account offers zero interest and inflation is 2 per cent, every year your money will lose 2 per cent of its value in real terms.

Spread Your Money

Instead, experts advise that you spread your money around a few different types of investment, and some key strategies are considered below.

The following considerations are variables that professional advisers apply before recommending an investment strategy they consider appropriate to your individual circumstances, attitude to risk and financial objectives.

Following the Retail Distribution Review advisors are obliged to charge fees rather than take commission on the products they advise on, and in many cases these fees could be significant.

Suitably educated and sufficiently well-informed, it is believed that many will choose to take control of at least part of their financial affairs, and some core principles of investment strategy are considered below.

The Basics

Even the term ‘asset allocation’, could be designed to protect the livelihood of those wishing to charge for their professional opinion.

Asset allocation should not be considered a dark art, it merely describes the different types of investment that make up any given portfolio, and it is the balance or weighting given to each asset class that reflects the attitude to risk and objectives of the investor.

A basic understanding of some of the terms that are used will hopefully serve to demystify the process.

Diversification

Putting everything into the stock market, even across a few different company shares, can be as risky as putting everything into the bank account. Similarly, just buying UK government bonds may not be wise.

Mr Bond says... "Every investor is unique, but everyone faces the same trade-off between risk and reward. Put simply, you can’t hope for long-term above-average returns unless you are willing to take on more risk."

The solution provided by the professionals is that of diversification; simply, splitting your money across different types of investment – known as asset classes.

Aside from cash, the two asset classes of most interest to investors are equities(stocks and shares) and fixed income (bonds) and each comes with advantages and disadvantages.

Investors in shares effectively own a small part of the company they select and historically equities have been proven to rise more in value over time. If the company is successful in growing its profits, more investors will want to buy its shares, driving the price upwards.

Limiting Risk

However, share ownership comes with greater risk. If a company does worse than the market expects, shares can fall dramatically in value. This risk can be limited by investing in massive companies, like supermarkets, banks or utility firms, but even here you can still lose a surprising amount: a £100 into Royal Bank of Scotland made shares in 2007 was worth less than £10 five years later.

Bonds are safer. You buy debt, for example debt issued by a government (gilts) or corporation (corporate bond) and the company or country pays you back over a set period (hence fixed income) so that you get back more than you put in. However, ‘gilt-edged’ government debt can seem, recent experience confirms that even governments can go bust; the rate of return that can be achieved from sovereign debt indicates the perceived strength of the issuing economy.

Bonds v Equities

The downside with bonds is that you stand to gain less than with equities.

For example, £1,000 invested only in bonds in 1956 would have grown to £56,060 by 2008. But the same amount invested in equities would have left you with £362,740.

The decision to choose one asset class over another is made somewhere along the risk/return curve – put simply the higher the risk, the higher the potential return and also the greater the potential loss.

Conversely, having mitigated the risk of a break in, putting cash in a sock under the bed is vulnerable only to the corrosive effect of inflation, although there is, of course no potential upside.

For the sake of comparison, equities are much riskier than bonds; charts of equity and bond returns since 1956, show much bigger swings, up or down, in equities than the bond chart. The measure of how big and how frequent these swings are, is called volatility.

Volatility

Equities are much more volatile than bonds. You might get back more than you invested if you wait long enough, but there’s a much bigger chance that when you want to sell, you’ll have to sell at a loss.

Therein lies the conundrum - slow and steady bonds, or racier and riskier equities. The answer in a balanced portfolio is normally a bit of both, with a cash element thrown in for emergencies.

How do you decide what balance is right for you?

Make it Personal

Why are you building a portfolio?

Most of us will have key financial objectives that could include purchasing a property, university fees, paying off our mortgage or planning for our retirement.

With differing time horizons for each element, the central task is to build a pot of money that involves taking some risk over the long term, at the end of which ideally you will have built up a sizeable portfolio of diversified assets.

Risk and Reward

Investors with only short term objectives are typically less willing to take on risks – they might for instance only be saving for ten years to cover school fees, and will be looking to avoid volatility and reduce risk. Alternatively, they may already be in retirement and need to generate an income whilst preserving their money against inflation, even at the cost of future opportunity.

For both of these latter groups, a sensible investment strategy is likely to involve a relatively low level of ‘risky’ assets such as equities.

Every investor is unique, but everyone faces the same trade-off between risk and reward. Put simply, you can’t hope for long-term above-average returns unless you are willing to take on more risk.

The holy grail of double-digit year-on-year growth is possible only by risking the loss of a substantial chunk of assets.

Economists agree that investing in equities is only a sensible option for the long term; at least five years, if not ten. They’ll also tell you that if capital preservation (avoiding losses) is your primary objective, you should probably steer clear of stocks and shares, and stick to less risky, less exciting assets such as bonds and cash.

If you’re saving for the long term and can stomach the potential volatility and downside, then, put more into equities. But if you’re a short term investor looking for guaranteed returns or already retired, favour bonds.

Diversify and Create a Balanced Portfolio

Diversification involves ensuring that your overall portfolio includes a mixture of high, medium and low risk assets that reflect your attitude to risk whilst allowing you to achieve your personal financial objectives.

One pool of your assets may consist of risky investments such as equities, commodities and all manner of alternative investments including infrastructure funds. Another may consist of assets with less risk (although not ‘no risk’) such as bonds (government or corporate) and cash.

A key task in this context is to create a balanced portfolio is to match up your personal objectives and tolerances to a mixture of diversified holdings.

This might end up looking like a 40/60 blend of low-risk/high-risk assets or any other combination based on your tolerance of risk.

If you are especially risk friendly and have a long time horizon, you might be willing to put 100 per cent of your portfolio into risky assets; if capital preservation is the priority, you might stick with 100 per cent low-risk assets.

Changing Over Time

As you grow older and your requirements change (as well as your perceptions of risk) your portfolio of assets must also adapt.

Mr Bond says... "Set your objectives, and understand your appetite for risk."

To give you an idea of how your portfolio might change, lifecycle or lifestyle funds have been developed. These funds mix equities, bonds and property assets in different proportions according to how close the holders are to retirement (or how far beyond it).

Simply put, they start with 100 per cent of assets in risky equities for a worker in his or her thirties, then end with a portfolio where 75 per cent is allocated to low-risk bonds for an investor into his or her retirement.

A self-directed investor can emulate this shift over time by ensuring that the balance of their portfolio changes to reflect this evolution, potentially with a shift toward investments that deliver a more certain outcome.

Whilst not a precise science, many model portfolios are available to be viewed or potentially mirrored.

Buy and Hold

Any rearrangement of your portfolio should be controlled and measured with a view to minimise the amount of capital lost to fees.

With a distinction to be drawn between ‘traders’ and ‘investors’ historical analysis of returns suggests that investors shouldn’t over-trade, shouldn’t try to time the markets, and absolutely should avoid turning into speculators.

Consensus suggests that private investors should work out a long-term strategy, build a diversified, robust portfolio and then sit tight as a buy-and-hold investor.

Research shows that the most active traders (averaging over 250 per cent portfolio turnover annually) earned 7 per cent less per year than buy-and-hold investors, who averaged just 2 per cent portfolio turnover.

It’s simple. Every time you trade and change your asset allocations based on a hunch, you’ll incur transaction and, potentially, advisory charges.

By way of illustration, a £50,000 savings pot seeking an annual return of 8 per cent per annum would be eroded by more than £100,000 over thirty years by the addition of a seemingly innocuous 1% in trading commission.

That’s the Basics of a Balanced Portfolio

And they are surprisingly simple.

Set your objectives, and understand your appetite for risk – many calculators are available to help you do this.

Decide if you are confident enough to take full control, or whether you would be more comfortable taking on part of your financial planning and paying for partial advice until your knowledge and confidence levels rise.

Work out your own investing style and then make sure that your diversified mixture of asset classes mirrors your own risk-reward trade off.

If you’re willing to embrace higher risk levels and won’t need the money for a while, think about tilting your portfolio towards shares. If you only have a narrow time horizon for what you want to achieve from your investment, give more weight to bonds.

Aim to keep costs within your portfolio as low as possible, don’t over-trade, and remember to keep a watchful eye on the balance of your portfolio as your objectives and circumstances evolve.

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