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Justin Urquhart-Stewart: The Second Rule of Investing: Risk & Asset Allocation

We all want as much as we can get, don’t we? Although perhaps not at any cost. It is a fact of human nature that most people want as much return as they can have, so long as they don’t risk losing it! But the situation is “no risk = no gain”, so here is the imponderable: what are we willing to risk?

Risk is very personal and difficult to properly measure, but as a rule of thumb I would suggest it is being able to sleep at night. If you are fretting about losing your money in an investment scheme and it is preying on your mind, then you are probably taking too much risk.

So how can we consider this imponderable more technically than sleep deprivation? Well the first issue is time. Investment in my view is a long term game, and anything under five years is too short a period for your investment to work properly.

Now past performance is no guide to the future, but we can measure the volatility of different asset classes that you may be using. So, if we blend together different investment asset types, which tend to have different levels of volatility, we can start to improve the predictability as to how they are likely to behave.

Thus cash is going to be less erratic than European shares, but by blending them together we can see how your portfolio would be affected by them both. Adding more asset classes, including everything from shares around the globe, to bonds, commodities, property and various others, results in a much deeper blend of all these investment types giving us a portfolio with a more manageable volatility and predictability. With the ability to measure the volatility or risk you may suffer in any investment blend, it is possible to customise the risk level, and find something that your no doubt somewhat frayed investment nerves might be willing to tolerate.

Asset allocation is the key factor in the variability of long term returns

The blending of all these asset classes is referred to as Asset Allocation, and is generally accepted as being the most important driver for longer term investment returns. A quick Google enquiry will show that Asset Allocation is probably responsible for around 90% of your longer term historic returns. Stock selection and market timing may be important, but if you are in the wrong asset class to start with then you are going to have a fundamental problem.

A quality institutional investment manager will diversify their risk by this spread of asset classes both by type and global geography. By definition you will miss out on having all your bets on the winner, but you gain a huge reduction in risk and hopefully have a more predictable return.

However, you don’t have to leave it there. Firstly, you can adjust your asset allocation as you see events change, and also adjust your risk levels according to your own frame of mind. If you want to take a greater risk then you can just increase the holdings of those more risky but potentially more exciting investments in a given section of your portfolio. So for example, the younger you are the more likely you are to accept a greater risk, on the basis that you have more time to recover from any disaster. Then as you get older, your attitude to risk will become more defensive as you don’t want to lose your hard earned monies just when you are going to need them most.

So asset allocation should help you manage your risk, and managing your risk should help you get a good night’s sleep. Rule Two!


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