Investing Basics: Building a Balanced Portfolio

Those seeking a better rate of return and to take more control of their financial future, could consider building their own investment portfolio.

 
Many options exist in terms of ways to invest and account types, and these will be explored elsewhere on this site, but 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.

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; if your current account offers zero interest and inflation is 1%, every year your money will lose 1% of its value in real terms.

As inflation creeps towards double digits, you could be losing ten percent of the buying power of your money each year.
 

 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 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, 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 type of investment, or 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 risky; similarly, just buying UK government bonds may not deliver the desired outcome.

‘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 asset classes.

Aside from cash, investors may consider equities (stocks and shares), collective investments (Unit Trusts, OEICs, Investment Trusts) passive investments (Exchange Traded Products or trackers) fixed income (gilts and bonds) and alternative investments (inter alia, P2P, crowdfunding, commodities, property); 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 in value more than other asset classes over time. If the company is successful in growing its profits, more investors will want to buy its shares, driving the price upwards.
 

Understanding Risk

 
However, share ownership comes with potentially 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 large ‘Blue Chip’ companies, like supermarkets, banks or utility firms, but even here you can still lose a surprising amount: a £100 invested into Royal Bank of Scotland shares in 2007 was worth less than £10 five years later.

By contrast, bonds are safer; you ‘lend’ money to a government (gilts) or corporation (corporate bond) which undertake to pay you back a guaranteed amount over a set period (hence ‘fixed income’) which may be attractive for those looking for guaranteed income in retirement.

DIY Investor looks at the theory behind each asset class but also looks under the bonnet by delivering the inside track from the product issuers themselves as well as the practical experience of investors seeking to address financial issues just like you.

It also looks at products where it is possible for the investor to lose more than their original investment believing that education is the key to making informed investment decisions.

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.
 

 
For example, £1,000 invested in bonds in 1956 would have grown to £56,060 by 2008, but the same amount invested in equities would have generated £362,740.

Collective investments – whether actively managed funds or passive trackers – come with ready made diversified exposure to a wide range of assets, sectors and geographical locations.

Some products are ‘geared’ or ‘leveraged’ which means getting exposure to an underlying asset without paying the full cost.

This may at first sight appear daunting, but think of it in terms of how we use a mortgage to purchase a property.

Few of us can afford to purchase a property outright, so we take out a mortgage; with a deposit of £50,000 and a mortgage of £250,000 it is possible for you to have exposure to an asset worth £300,000.

Theoretically, if your house increases in value by 10% to £330,000 you could sell it, pay back the bank and pocket the remaining £80,000. That’s £30,000 more than you invested, and a 60% profit from a 10% rise in the house price.

In investment terms this is called ‘6 times gearing’ as your profit is 6 times greater than the move in the underlying asset. Importantly, there is another lesson to learn. Gearing works against you too. If the house falls in value to £270,000, your equity would be slashed to £20,000 as you still owe the bank £250,000.

At the other end of the risk spectrum, 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.

Individual equities are generally riskier investments than fixed income or collective investments and show much bigger swings, up or down, in price; the measure of how big and how frequent these swings are, is called volatility.
 

Volatility

 
Depending upon the company the investor chooses, individual equities may be more volatile than other asset types; you might get back more than you invested, but there’s a greater chance that when you want to sell, you’ll have to sell at a loss.

There is also a risk/return curve within asset classes – Blue Chips are likely to be less volatile and deliver more predictable income (dividends) but are unlikely to deliver the potentially stellar performance that may be achieved by some AIM, or ‘small cap’, stocks.

Therein lies the conundrum – slow and steady or racier and riskier? 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 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 risk 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. If you’re saving for the long term and can stomach the potential volatility and downside, then, put more into equities.

If you’re a short term investor looking for guaranteed returns or already retired with capital preservation (avoiding losses) as your primary objective, you should probably stick to less risky, less exciting, assets such as bonds and cash.
 

Create a Balanced Portfolio

 
A balanced 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 or P2P.

Another may consist of assets with less risk (although not ‘no risk’) such as bonds (government or corporate) and cash.

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.

‘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% less per year than buy-and-hold investors, who averaged just 2% 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 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 more predictable returns.

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.
 
As we say – Do it Yourself, Do it With me, Do it For me – just don’t do nothing!