2 Perspectives On Reducing Risk To Increase Your Investment Profits
By Alex Pritchard
When building an investment portfolio, it is important to minimise risk as much as possible to a level you are comfortable with. This is one of the fundamental benefits of collaborating with independent financial advisers – they are well-qualified to help you explore your options and make the choices that will offer you the best return.
However, what exactly does minimising risk in your investments look like?
When considering where to put your money, there are only four options:
- Cash – This is the poorest investment of the four. Even with the currently rising interest rates, it offers little value.
- Property – Commercial properties specifically look good right now. It will not make the most money, but businesses will always need space to operate. Even remote operations need warehouse space or a place to keep servers for cloud computing.
- Fixed interest – These investments are less attractive in general, which means that they tend to form only a small part of our portfolios. That said, with the current rising interest rates, they are paying out well at the moment.
- Equities – UK-based equities are looking very attractive right now. Those that are particularly secure and sizeable are paying decent dividends.
When it comes to the success of your investments, there are two ways to view risk:
The first focuses on volatility – how much and how quickly the value of an investment can change. In previous blogs, we have discussed how to minimise this type of risk: through diversification. The greater variety a portfolio has in the sectors, markets, and regions that its investments cover, the more protected it is against sudden changes.
The second considers the investment’s yield – while the value of investment itself might not be volatile, unforeseen costs and expenses might reduce the return or eat into your profit. We discussed this in our blog on buy-to-let properties – as the market is currently struggling, the costs of running a rental property right now make the investment riskier.
Ensuring diversification through asset allocation
What most advisers do to help create a diversified portfolio is use a process called “asset allocation”. Based on collected data from the last 20 to 30 years, the money in the fund is divided in a ratio that essentially never changes.
An example of how assets would be allocated regionally across established and emerging markets might look like this:
- The US – 65%
- The UK – 7%
- Europe – 5%
- Japan – 5%
- The remaining 18% divided across various other countries and emerging markets.
However, this approach may be an unnecessarily higher risk than it could be. An asset allocation that never changes does not fit well with a longer-term investment strategy. In the example above, there’s a heavy focus on the US. This is based on 2020, when its tech sector boomed and there had been a general high performance in previous years. This year, however, the US market has been underwhelming.
Do you really want two thirds of your investments to be tied up in a market with assets that are expensive or not of good value?
Traditionally, that approach may not be seen as high risk because of its diversity. However, the purpose of diversity is to ensure value and a strong return – if value is poor, there is no growth, and if the US economy is struggling, is it really worth investing in for diversity alone?
Focusing on value and yield
While the US markets are struggling right now, the UK markets are looking exciting for investors. Currently, the pound is cheap and share prices are artificially low for reasons external to the UK market.
This means that the yield – the income generated by the investment – for UK assets should be far stronger than other competing markets. As the cost to invest in the first place is far lower, while the dividends returned are higher – I estimate it’s going to be about 10% this year – I consider that the UK markets are actually a lower risk investment.
How I manage risk in our portfolio
Accordingly, my portfolio at the moment is relatively focused on the UK. While I do have some overseas investments, which admittedly are not yielding as much as those in the UK, they are only there because it is important to maintain diversity and not put all your money in one place.
Diversity is a useful protection against volatility, however the purpose of an investment is to work for you and provide value. If you can build a portfolio that focuses on value – assets which are cost-efficient to invest in but with a strong yield – that is better than focusing on diversification for the sake of having diversity.
So, when it comes to risk, it is more important to consider the true value of what you are buying now, not whether it has simply been seen as high or low risk in the past.
This is the philosophy that underlies all of our successful portfolios. Our focus on the value of what we are buying helps us to ultimately provide investments that provide the most returns at the maximum possible efficiency with the lowest risk we can get away with.
At Applewood Independent, we love everything to do with building and maintaining strong portfolios – nine times out of ten, we get it right. For more useful insights as to the state of the market and how to make investments that fit your needs, why not listen to our new podcast A Dab Of Investment?
The views expressed in this article are those of the author and do not constitute financial advice. Applewood Independent Ltd is authorised and regulated by the Financial Conduct Authority. For financial advice designed for you and your specific circumstances, please contact the author using the contact details provided in this article or, alternatively, contact the Applewood Independent Ltd office on 01270 626555.
The value of your investment can go down as well as up, and you may not get back the full amount invested.
Past performance is not a guide to future performance.