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. |
