Don?t Let Your Investment Risk Pyramid Become A Square


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A growing number of investors we meet are aware that they need a well diversified spread of assets to protect their wealth over the longer term. Generally, we are living longer and for many the i

A growing number of investors we meet are aware that they need a well diversified spread of assets to protect their wealth over the longer term. Generally, we are living longer and for many the impact of financially caring for elderly parents, as well as any children who still need financial help to get on the property ladder, does mean that over the longer term there are additional burdens on our wealth ? and that?s before you can fully enjoy your retirement financially.

I believe that there is a growing recognition that although cash in the bank is necessary for money that you?ll need in the short term, beyond that its value erodes after the impact of inflation and in the medium to longer term it?s really a one way bet in that it will lose value.

Equally, investing only in equities is a high risk strategy because although over the long term they have proven to provide inflation proofed returns, they are volatile and inappropriate for investors who may have shorter term needs for access to capital.

The way to build a diversified portfolio of assets is to start by establishing the basics:

? Your attitude to risk

? Your investment objectives

? Your investment time horizons

? Other assets owned by you that should be considered in terms of their place and risk impact on the overall portfolio.

With this information and working together with you, your wealth manager can begin to construct your portfolio. It is vital that you are included in the process so that you understand each component of the portfolio and why it has been recommended.

The investment pyramid

Although each client portfolio will be different to reflect its owner?s uniqueness and different needs, portfolio building techniques usually result in an investment pyramid being established. In essence, larger amounts allocated to lower risk assets will usually form the base of the pyramid, with lower amounts being allocated to the higher risk assets at the top of the pyramid.

The importance of the pyramid is to ensure that the portfolio is not over exposed to any particular area and it?s used as a technique to help reduce the overall volatility of the portfolio.

The specific investment recommendations may not in themselves represent a pyramid, however once any other assets you own are included, the overall approach should represent a pyramid.

For example, if you are looking for long term growth and are prepared to accept some volatility in the short to medium term, you may have a pyramid as follows ?

? 40-45% fixed interest bond funds

? 30-35% property funds

? 20-30% equity funds

It must be remembered however that each portfolio recommendation should be based specifically on the core fundamentals of your risk tolerance, investment objectives, timeframe and other assets.

If you are looking for income from your portfolio, this is typically generated from the fixed interest bond and property elements, whilst the equity component will seek to provide longer term inflation proofed growth for the whole portfolio.

Periodic reviews

Once the investment strategy has been established it is important to review it at various stages.

The review is important in that it is the time when the core fundamentals can be confirmed or re-established. In the interim has your ?

? Attitude to risk changed?

? Investment objectives changed?

? Are your investment time horizons still the same?

? Other assets held outside of the portfolio changed?

? Have your personal circumstances changed

Any changes to any of the above factors may require the portfolio to be amended to reflect any change in circumstances.

The problem with investment squares

As each portfolio will be constructed with different asset types which carry different levels of risk and growth expectations, over time it is possible that the higher risk and higher growth components of the portfolio will grow faster than the lower growth assets at the bottom of the pyramid. Hence the shape of the pyramid may change into something more similar to a square where there are equal amounts invested in high risk assets as there are in lower risk assets. In extreme cases, as a result of growth it is possible that the pyramid becomes inverted to the extent that there are more in higher risk assets than in lower risk ones.

Clearly, any change of this nature will change the risk profile of the whole portfolio and it is therefore important that each portfolio maintains a consistent approach with the attitude to risk and objectives of each client i.e. it continues to be a pyramid.

Risk is not constant

Contrary to popular belief, risk is not constant. A simple example of this is in relation to cash in the bank. Excepting the recent banking crisis, conventional wisdom would say that cash is a low risk investment. Actually, the investment risk attached to cash differs based upon whether you are planning to hold it for the short term or the longer term and whether you will withdraw the interest to spend.

So, if you are holding it for the short term then it is arguably low risk; if you are holding it for the longer term it becomes higher risk and if you are holding it for the longer term and withdraw the interest each year, it becomes very high risk.

Assets such as equities have a reverse profile in that the longer you hold them, the lower the risk becomes. Equally, the higher equity prices rise the higher the risk of a fall – and the lower they fall so does the risk attached to them.

Rebalancing portfolios on a periodic basis will reduce exposure to assets that have performed well above expectations – and therefore where the risk to those assets has increased – and re-allocate it into assets that may have done poorly and which therefore now have lower risk.

In effect this approach can help lower the overall risk to the portfolio over time and also can assist in providing smoother returns.

If you want to protect your wealth from the impact of inflation over the longer term you should only take regulated and authorised specialist advice from a company such as Blevins Franks Financial Management Limited.

By Bill Blevins, Managing Director, Blevins Franks

18th May 2010

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.