Return, risk and building a portfolio
Returns and risk are often two sides of the same investment coin. Understanding both is key if investors want to achieve their financial goals with the fewest possible hiccups.
Returns are usually well understood because they are easily calculated after making an investment. Focusing on risk and diversification helps investors comprehend not only the outcome of investments but also how and why those results were achieved.
Risk and the Stock Market
Risk can measured in lots of different ways. Very simply, it is an estimate of the chance an investment will lose money.
And in the short term at least investing in the stock market is risky. Over the last 10 years, the index has gained in 281 out of 521 weeks as measured by the Halifax FTSE 100 Tracker, which is about 54% of the time.
Invest in the stock market for a week and your chance of losing money is not much different from calling heads or tails on a coin toss.
Long-term investors have achieved better results. Research by Barclays shows that the chance of the stock market delivering returns lower than bank deposits over 10 years is just 8%. Over 18 years, investors have historically made money in 99% of all historical periods going back to 1900.
On a weekly basis, the odds are only very slightly in investor’s favour.
Over the long term, even a small advantage compounded week after week should result in very satisfactory results.
Adopting a long-term investment perspective is one way of reducing the chance of investment disappointment. Another method of reducing the risk of investment losses in the short and long term can be achieved through diversification. Diversifying means adding new assets to a portfolio with the aim of keeping returns at an acceptable level while reducing risk.
The most obvious example of diversification is seen in the stock market. Owning shares in one individual company is riskier than owning shares in an index fund which invests in 100 companies. If one company in an index goes bust, it only reduces the value of an index tracker by a small fraction. If that company happens to be your only investment, the results are devastating.
Diversification is also important across asset classes. A portfolio which only has stock market investments is riskier than a portfolio that has stock market investments and bonds, for example. Most balanced investment portfolios include a mix of UK and international stock market investments, bonds, real estate, private equity and commodities investments.
If global stock markets fall, there’s still a decent chance that the portfolio’s bond or commodities investments will increase in value. This means poor performance in one asset class does not hurt the overall portfolio too much.
Know what you own
Diversification also means thinking about your own unique set of financial circumstances and building an investment approach which fits. Property is often the single largest asset of most households in the UK. For property owners, finding assets with good returns which are unrelated to the property market is wise.
Equities have a surprisingly low long-term correlation with residential real estate, according to research produced by M&G Investments. UK gilts have a negative correlation: their value tends to rise when house prices fall. There is some evidence commodities, and particularly gold, also have low correlations to UK residential property.
Importantly, different types of investment make sense for different people in different financial circumstances. A big investment in the shares of a construction company like Berkeley (BKG) might make sense for someone with no property assets. That is unlikely to be the case for someone who has just bought their own home and has a large mortgage – it would only serve to magnify their risk in the property sector.
The composition of an investor’s existing assets is a key consideration in what assets they should invest in next.
Getting to grips with what you already own and identifying the best thing to do next is one of the most fundamental elements of investment.
Consulting with a financial adviser, conducting research through books like The Intelligent Asset Allocator and, of course, subscribing to Shares are all great ways to help answer that question.