Is your investment strategy too cautious?

Published by Rob Griffin on 07 April 2008.
Last updated on 25 August 2011

We’re often told to be sensible and tread cautiously when it comes to investment. But if you’re putting money away for the long-term you may eventually discover that this strategy has fatal flaws - particularly if it means avoiding the stockmarket.

By their very nature, cautious investments – those based on cash and fixed interest – take extremely low levels of risk and are usually only capable of generating modest returns.

But to stand any chance of seeing the value of your investments really grow over time, you need at least some exposure to the so-called racier asset classes.

Therefore, plough every penny into savings accounts paying minimal amounts and fixed interest products – before leaving it for 40 years - and you could be in for a nasty surprise when you try and use it to fund your retirement. And with company pensions becoming less generous by the week, making sure of having enough money to enjoy a comfortable retirement is our individual responsibility more than ever before.

According to Darius McDermott, managing director of Chelsea Financial Services, the value of your money will actually decrease unless your investments earn a return substantially higher than the rate of inflation.

Considering the latest data from the Retail Prices Index – acknowledged to be the most accurate barometer of living costs in the UK – show inflation running at around 4%, your portfolio needs to be growing by well in excess of this figure.

“Inflation erodes your investment, which means that if it was at 4% and cash is at 5% then your real increase is just 1%,” explains McDermott. “In comparison, if equities do 8% then your real return is 4%.”

With markets currently looking uncertain, there’s a good chance that the return from equities will be negative this year, but it’s important not to become too hung up on this point - if you want to out-perform inflation over the long-term then you need to take riskier assets into your investment equation.

Before diving head first into more perilous waters, however, take time to consider your attitude to risk, because the simple fact is that no investment is risk-free. Therefore, before you invest you will need to decide how comfortable you are with the prospect of losing your money – even if it is only a short-term loss on the way to longer-term gains.

The definition of risk varies between individuals. Broadly speaking, however, it can be classed as the impact that losing all the money you have invested would have on your overall lifestyle. In other words, only invest what you can afford to lose.

It’s also worthwhile bearing in mind that while the value of your investment may go down, you will only make an actual loss if you cash in at that moment. Until then it is only a paper loss and you still have the possibility of it eventually rising in value. So while it’s tempting when you see stockmarket plunges in the news to get your money out as quick as possible, this is almost always the worst possible thing you can do.

Long horizons

This is an important point, argues Richard Philbin, director of funds of funds at F&C Investments. While favouring equities over property, cash and fixed income products, he insists it’s important to have relatively long investment horizons.

“Our view is that equities are the best way to make the most money, but it will also be the most volatile,” he says. “The average long-term return from the stockmarket is 7% or 8% – but this can be give or take 15%t.

Therefore, investors shouldn’t be shocked if their £100 investment shrinks to £80 in the first year.”

This is particularly relevant given the stockmarket turbulence in 2008. The average fund in the competitive UK All Companies sector has lost 10.9% over the past year, according to figures compiled by Morningstar to 11 February. However, the same investment will still have been up 23.8% over the past three years to that date, while the return over five years stands at 95.7%. And remember, that is just the average performance. Some will have done a lot better.

For example, the number one ranked fund in the sector over that five year period is the Old Mutual UK Select Mid Cap Fund, run by the highly rated Ashton Bradbury, which has delivered an impressive 206.9% return.

But the statistics show that even he is not immune from stockmarket slumps as the fund has lost 10% over the past year and for the cautious investor this represents a nerve jangling period.

While it is virtually impossible to time the stockmarkets, one way of tackling such volatility is a savings technique known as pound cost averaging. This works by paying in a set amount each month to buy units of a fund.

“If you regularly invest £200 into the fund and have been buying units at £9 each, when they fall down to £7 you will get more units for your money,” explains McDermott. “You get an averaging effect and it’s a great savings discipline.”

Although you can’t eliminate risk from your investments – and nor should you want to if you’re hoping to make decent long-term gains - you can manage it better by having exposure to a broad range of asset classes.

This is known as diversification and basically involves splitting your money up and investing in a variety of different investment types in the hope that losses suffered by some will be balanced out by gains made elsewhere.

How much you have in each asset class depends upon your personal circumstances and long-term investment goals. As a general guide, the following are types of investments considered by those with different risk appetites.

Cautious investors –who typically shy away from stockmarket volatility – will probably prefer to have the bulk of assets, say 60%, in fixed interest positions, and only a 20% exposure to UK equities in the portfolios.
More balanced investors, meanwhile, would reduce the amount of fixed interest to around 30% and have a wider spread of equities. This could result in a 25% exposure to UK equities, along with 15% in US stocks, 12% in European names and maybe 8% in the Far East and emerging markets.

If you’re a more aggressive investor, you would generally shun fixed interest and focus their attention on equities by increasing the weightings – listed above – in different areas of the world.

According to age

Obviously your age will play a part in this as your investment priorities will change according to what’s happening in your life and the demands on your money, says Andy Merricks of Brighton-based IFA Skerritt Consultants.

“When you are young you can afford to take a long-term risk so you should be heavily exposed to equities – including overseas companies,” he insists. “You are trying to build as big a pot as possible and that’s not achieved by being too cautious early in your saving career. History tells us that over the longer term equities are the best place to be, so why would you not be exposed to them in your twenties?”

However, your perspective and horizons will change with age. While an aggressive stance makes sense in your twenties, thirties and, in most cases, early forties, caution certainly pays when the clock is ticking towards retirement.

“If you come within six months of retiring and still have 100% exposure to equities then you would need your head tested as something will have gone wrong” adds Merricks. “You just need to be sensible about where you put your money.”

Similarly, you need to be in a financial position to invest, says Mark Dampier, head of research at Hargreaves Lansdown. “The ideal scenario is to have between three and six months’ money behind you before you even consider investing in fund – regardless of your attitude to risk,” he says. “Having a solid foundation is vital, along with immediate access to cash should you suddenly need it for an emergency or if you lose your job.”

Diversification aside, one option for long-term investors that are not lovers of risk and don’t feel comfortable chancing their arm too much is to consider UK Equity Income funds, suggests Merricks, as they offer a particular advantage.

“They will be mostly exposed to equities but you’ll be reinvesting the dividends over time so you enjoy the compounding benefits of dividend growth in your portfolio,” he explains. “It’s a very powerful tool and makes a real difference.”

Take the example of someone wanting an 8% annual return. “If you are getting a reinvested dividend of 3.5% then the underlying stocks in the portfolio only need to rise 4.5% to hit your target,” Merricks says. “That is quite a modest expected return.”

Another possible option is the new breed of multi-asset funds, which invest in a broad mix of asset classes, including equities, bonds, property and private equity. The theory is that they will provide decent returns - and a less bumpy ride.

“You name the asset class and it will probably be in there,” says McDermott. “They contain a host of uncorrelated assets and aim to deliver an equity-like return, but with a bond-like volatility. In investment terms this is the holy grail.”

A number of these funds have worked well during the bout of volatility that gripped the market during early 2008, with the Insight Diversified Target Return fund a good example.

While the average fund in the UK All Companies is down 10.2% over the past three months, this fund is down just 0.2%. “It’s bound to have gone down because it is exposed to equities,” points out McDermott. “However, it certainly hasn’t fallen as much as the market – or the more equity focused funds.”

When it comes to predicting which sectors will be the best performers over the coming years, however, you’ll need a crystal ball.

A comparison by the Investment Management Association of which areas have delivered the best returns over one and 10 year time horizons, illustrates the point.

The best performer over the past decade has been the European Smaller Companies sector, where the value of £1,000 will have, on average, risen to £3,699 as of the end of 2007.

However, as far as the last year is concerned, it barely scrapes into the top 10 with the value of a £1,000 investment rising just £62 – compared to the £364 extra you would have received by putting your money in the Asia Pacific Excluding Japan sector.

Similarly, if you had put £1,000 into the average Japanese Smaller Companies Fund at the end of 1997, you would have almost doubled your money by early 2008 with that investment worth £1,986.

However, if you had put the same amount in 12 months ago in 2007 you would have suffered a loss of £180.

According to Richard Saunders, chief executive of the Investment Management Association, these figures reinforce the message that putting your money into stockmarket investments for the longer-term makes sense.

“The published performance figures continue to show the benefits of investing for the long term, with the average investment in a UK All Companies fund returning 80% over the last 10 years,” he says. “This is despite the downturn in the markets at the turn of the century - and the recent volatility.”

So unless you’re in a position to ignore something offering the chance of that kind of long-term growth, the question isn’t whether you afford to take the risk – but, circumstances depending of course, whether you can afford not to?

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