Wednesday, November 16, 2016
Insights from our quarterly investment review
Recently we’ve been revisiting some of the assumptions we use when building investment strategies.
Our assumptions – not forecasts! – are anchored on the so-called ‘risk-free’ rate of return. This is the idea that investors can be reasonably sure of getting their money back if they lend it to the UK government. Investors putting their money elsewhere should demand a ‘premium’ for holding more risky assets.
This chart shows how far the yield on a ten year government bond has fallen over three years:
Bond yields fall as prices rise and vice versa.
Three years ago our long term return assumption for a medium risk portfolio was about 6% a year before costs and taxes. In fact, in the three years to the end of September 2016, portfolios like this went up in value by a third. That’s just over 10% a year.
Investors have been well-rewarded over this period – returns have exceeded expectations. But some of this performance has in effect been ‘borrowed’ from the future.
So our view is that returns are likely to be lower in the next few years than they have been in the recent past.
They may also be more volatile in the aftermath of the US election and as Brexit plays out. And at the same time there’s a danger that inflation might be higher.
In this situation investors can do one of three things:
- Accept lower returns
- Adjust their plans to factor in these expectations
- Change the risk profile of their investments
Having experienced good returns over the past few years, some won’t need to do anything at all. For those ‘ahead of the game’, if returns are lower it shouldn’t affect their goals. Others may be content to make small adjustments to their long term plans.
Another option for investors is to change the risk profile of their portfolio. In practice this means selling bonds and buying shares. This is because, over the long term, ‘risky’ assets tend to deliver higher returns – although the value will fluctuate more in the short term.
Paraphrasing risk tolerance experts FinaMetrica:
The expected risk and return of a portfolio depends on its defensive / growth asset split. Defensive assets include cash and bonds, and growth assets include property and shares.
Risk tolerance scores can be expressed as the percentage of growth assets to be invested. It’s best viewed as a range, and not a specific measure. So there’s a shading-in between comfort and discomfort, on both the upside and downside.
We’ve shown this in the chart below.
By way of an example an individual with a score of 55 could invest as little as 40% and as much as 60% of their money in growth assets staying within their ‘comfort zone’. They could invest between 30% and 70% experiencing only ‘marginal’ discomfort.
This pattern is consistent across all risk groups so in many cases it’s possible to increase risk enough to have a significant effect (assuming the individual has a high enough risk capacity) without causing sleepless nights.
With all this in mind we will be revisiting our planning for all clients at their annual review.
Despite the uncertainty out there the fundamentals of investing haven’t changed overnight. We encourage you to:
- Think again about your goals; and think about the risks you’re willing to take to achieve them
- Make sure you have enough cash – so you don’t need to sell investments if markets do fall (in the short term)
- Avoid knee-jerk responses and focus on the long term