#HowToInvestWell Stage Two - Assets
Imagine a perfect world, where we would all be able to generate the returns we wanted, the cost of everything we purchased would remain the same and everything we invested in would go up in value exponentially until the end of time. Now stop imagining that, your mind is playing tricks on you.
THE PROBLEM WITH RISK
The problem is risk. This is the possibility of losing money relative to the likelihood of generating a profit, and it is inherent in life. Nobody likes losing money and your individual attitude to risk can depend on many factors, but it is important to understand that risk is everywhere, it's how we manage it that counts. Some people take huge amounts of risk in their life, especially entrepreneurs, yet investment risk is a little understood topic and one that is vital to understand for our long term finances.
I regularly get asked by people I meet "what do you think is going to do better, shares or property?" The point is that nobody can say for sure and normally, if they tell you it is one magic bullet, it is probably because they want to sell you something.
In fact, investing has become more complicated than ever. This is because the 'risk free rate' (the return you would get for simply holding cash), has never been so low and it is expected to remain low for years to come. That might leave waking up at night in a cold sweat!
IS CASH STILL KING?
It didn't always used to be like this.... Prior to the financial crisis, interest rates on cash meant that you did not need to take much risk to generate a 4-5% return on your money. This was also generally more than the average rate of inflation - that being how much your money needs to go up by every year to maintain it's value, as the cost of the things you buy goes up
Now interest rates are at a historic low of 0.25%, it has forced people to take more risk than they are used to. This can be unsettling and many people have been sat in cash since the financial crisis earning less than the rate of inflation every year for the last 8 years. If you had a £1,000 in 2008 and held it in cash earning no interest, it would now be worth £827.10 (assuming 2% inflation since 2013). This would mean that you are 17% poorer than when you started and despite taking "no risk" could actually create a worse outcome.
SO WHAT IS THE ANSWER?
It is important to understand that if you try to pick this year's winner, you are adding risk and increasing the chances of getting it wrong. But that misses the point, investment is a long term activity and if you are only investing for a year, that might not be sufficient time to allow an investment to work properly.
The key is to focus on the right blend of investment assets, such as cash, shares, fixed interest, property and alternatives as that is the biggest driver of returns, as shown below:
What are the most important risk factors?
When it comes to investing, time is your greatest asset and by spreading your risk across a wide variety of different types of investment, you reduce the chance of suffering a significant loss on your portfolio overall. It is important to note that it is not whether one energy stock is likely to outperform another, it is whether energy stocks are going to do well or not. Thus, getting the right mix of assets has the greatest impact on your returns.
You should also consider investing your money globally, as countries and regions can have very different types of risk, as well as the effect of currencies. Just look what has happened to the value of Sterling in the last year.
You may need to change the level of risk over time, as your priorities change. As an investor in their 20's is likely to have very different needs to that of someone who has retired.
All of these elements highlight the fact that whilst the assets may go up and down relative to each other in any one year, they should produce a mixture of income and capital growth over the long term that generates a sufficient return to meet your need.
Finally - Don't put all of your eggs in one basket! There are various types of asset you can invest in, each having it's own advantages and disadvantages. Therefore, concentrating on getting the right blend of assets to manage your risk, that way we might all sleep a little better....
If you found this article useful, please get in touch, as well as like and share this article using the link below.