In the context of personal finance, what do we mean by risk? If you boil it down, risk comes down to how much volatility you want to experience to achieve the associated return.
Traditionally, like most things, adopting a high-risk strategy in personal finance can lead to high returns, but only if managed correctly. Here at Applewood Independent Ltd, if we look back over the last 10 years or so, we can see that our riskiest portfolios performed the best, so it can be easy to assume that the more risk you take, the better returns you will have.
But forget what’s happened in the past. At the end of the day, risk has to come down to efficiency.
Taking an efficient approach to risk
If you want to make a lot of money, you could easily take £100,000 down to the Grand National, put it on a horse, and maybe you’ll come back a millionaire. Maybe.
You’ve taken loads of risk and, if you win, you have got a big return. However, if you back the wrong horse, then you go home with nothing.
This is why we have to look at efficiency when it comes to our approach to risk in the world of personal finance.
There are all sorts of statistical analysis calculations that we can do with our clients, but let me give you a simple example of what I mean.
Let’s say a portfolio with a huge amount of risk produces a 10% return, but a portfolio with a very minimal amount of risk produces an 8% return. In this case, it’s far better to have made the 8% because you’ve taken dramatically less risk to do so.
This is our approach to risk at every level. You’ve got to be efficient with risk so that your potential returns increase without taking any unnecessary risks to get there.
The four main asset classes and their risk
When it comes to personal finance, there are four main asset classes you can put your money, and each one has its own risk factor associated with it:
- Commercial property
- Fixed interest
First off, let’s take cash off the list. There is no point in investing in cash because there is no money to be made there.
The next one is commercial property. This can be split into UK commercial property and overseas commercial property, overseas tending to be the riskier of the two (the same goes for fixed interest and equities).
Commercial property – the safer bet
Commercial property as an asset class is totally different to everything else out there. Although it still has a place in portfolios, it has probably less of a place now than historically.
Out of the three asset classes worth investing in, commercial property funds are probably going to make the worst return, but when you have a recession (other than the credit crunch, of course), they can help you mitigate your losses. This is because property doesn’t care so much which way the markets go.
It might only average 2% or 3% per annum, but if the market drops 40%, and there’s a recession that isn’t linked to property, that commercial property may still make a little bit of money, which helps the portfolio in the downtimes.
Commercial property funds are pretty consistent and great for the lower-risk portfolios. They effectively de-risk any portfolio by adding an air of stability to it.
Fixed interest – a portfolio staple
The next asset class is fixed interest. In most portfolios, you need more fixed interest assets than commercial property, even in low-risk portfolios. This is because fixed interest reacts in a different way to property and can be partially swayed by investment markets, which can allow for some potentially good returns.
The main point here is that these two asset classes I have discussed so far behave very differently, which means by adding them in, we are adding diversity to our portfolios and efficiently managing the risk.
On a portfolio that needs to make the owner an income, fixed interest assets are useful because they produce an income that isn’t a dividend, which can be tax-effective. Some fixed interest bonds have been known to pay 5% and 6% per annum interest, which is great!
Fixed interest funds have performed better than commercial property funds historically, and because they aren’t totally exposed to the stock market, can provide some protection against volatility too. This makes them a staple for most low–medium-risk portfolios out there.
Then you get to the last of the three asset classes worth investing in: equities.
Equities – higher risk, higher reward?
Equities are the biggest determining factor for risk in any portfolio. Most people making their own investments tend to have a portfolio made up entirely of equities which, for us at Applewood Independent Ltd, is a 10 out of 10 risk factor. Equities are completely exposed to the stock market, which means they will be heavily affected by any volatility in the markets.
Even with geographical diversity, if it’s equity, then it increases the risk of the portfolio dramatically. However, over a 5–10 year period, the portfolios with equities have also made the most money.
Finding the right portfolio for you
When it comes to personal finance, everyone will have a different definition of what is too risky for them, which is why it’s important you build the right portfolio for you.
This is why we always make sure every client of ours goes through a comprehensive psychometric questionnaire that tests the tolerance someone would have to risk. Then, we build a diverse portfolio of various assets based on their risk tolerance.
So, if we have several UK funds in a portfolio, they will all be doing a different job. The aggressive funds (mostly equities) are there to make money and the cautious ones (like fixed interest and property) to produce an income. Then we have other funds in the middle with unusual equities that provide an opportunity to make money in new sectors.
A great example of a middle fund like this would be investing in green energy.
Managing risk requires experience
Our approach to risk is to mitigate it by being well diversified, and that’s not something that we see too many other advisers doing today. At Applewood Independent Ltd, we’ve developed our risk approach over decades of experience. This not only gives a very positive upside in the good years in the market, but we’re also losing considerably less in the very worst times, as we saw in 2020.
Some of our funds actually made profits whilst the market was falling last year. And when the UK market rebounded, our portfolios were at an all-time high in performance terms! This was mainly due to our approach to risk and having diversity, through extensive research of each fund and knowing what will be good value in the future.
Speak with an independent financial adviser
Managing risk effectively is just another reason why you need to consult an independent financial adviser before making any big decisions on your financial future. Someone with real, solid experience will approach your money without getting emotionally involved. They can look at your money pragmatically and formulate a portfolio that’s not taking unnecessary risk.
With a good independent adviser, you will be potentially maximising profits on the upside, and should the market drop 30% again, you will be perfectly prepared for it.
I hope this has been useful, and if you have anything else to add I’d love to hear from you. To find out more, feel free to get in touch by emailing firstname.lastname@example.org.
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.