Cheat Sheet

Managing Your Investment Portfolio For Dummies (UK Edition)

The most important thing to you as an investor is your portfolio - the range of assets held within your stock-broking or investing account. Learn how to diversify your portfolio and reduce your risk by reading through this handy Cheat Sheet. Get tips on a range of asset classes and investment strategies and achieve positive returns in any market.

Deciding What Kind of Investor You Are

Investors come in many forms. In very general terms, there are the low-risk, very cautious investors and then there are the higher risk and more adventurous investors. See which category you fall into as an investor and what your drives and expectations are when it comes to your investment portfolio.

Here are some strategies that characterise the average lower-risk investor:

  • Absolute returns: Even low-risk investors like to think that they can make a positive return, which explains why so many are attracted to the idea of absolute returns; that is, making money in all markets, whether those markets are rising or falling in value.

  • Bonds: Bonds are likely to be a favourite in terms of asset classes, simply because they tend to be less volatile and produce income. Crucially, the promise to repay that’s implicit within a bond structure (at redemption) is likely to be very attractive.

  • Capital preservation: Lower-risk investors hate losing accumulated capital, and so tend to want to preserve their capital no matter what. Alternative assets, such as gold, that speak to capital preservation may make a fleeting appearance in the cautious investor’s portfolio.

  • Currency exposure: Currency exposure probably becomes less of an issue for cautious investors. They usually want to limit their portfolio of investments to those denominated in the currency of their home base.

  • Equities: Shares are likely to be much less attractive because they’re regarded, rightly, as fairly risky. If an exposure to shares does exist within the portfolio they’re likely to be blue chip stocks with strong balance sheets and sensible valuations.

    No intrinsic reason exists as to why cautious investors shouldn’t be interested in more sophisticated styles of investing that look to limit downside risk by hedging.

  • Income: This is critically important to many cautious investors largely because as they approach retirement they tend to turn their attention to eking out a monthly income from their accumulated savings.

And here are some strategies the average adventurous investor is likely to follow:

  • A focus on capital growth.

  • A willingness to make losses in the short term.

  • Less concern about income.

  • An interest in complex strategies that involve options, hedging and derivatives.

  • A global focus, including in their currency exposure.

  • A concentration on shares as their portfolio’s core component.

  • An emphasis within the share component of the portfolio on growth opportunities.

  • A great interest in alternative assets.

Realising the Risks Involved in Investing

Unfortunately, many investors look at risk in a very simplistic way. A typical query about risk may start with an investor asking, ‘How much capital may I lose if I invest in an asset?’ But risk involves much more than this narrow sense reveals and comes in many shapes and sizes. Try and think about risk in a much wider, sense and use the following pointers to guide you:

  • Credit risk: If you buy a bond, what’s the chance of the issuer defaulting on the final payment (or the regular interest payments)?

  • Currency risk: Your investment in a foreign asset may increase in value but the currency in which it’s denominated may move in the opposite direction.

  • Idiosyncratic risk: If you employ a manager to manage your money, what risk are you taking if he makes a bad decision?

  • Legal risk: Will regulators decide to change the rules governing your investment?

  • Leverage risk: What happens if you borrow too much money and the cost of leverage starts to work against your investment?

  • Liquidity risk: Your asset may increase in value but become increasingly difficult to sell; that is, it may become more illiquid, which is a risk if you need to access that investment immediately to raise some much needed cash!

  • Maximum drawdown: The potential maximum loss over a period of time that may hit your financial asset. Many stock markets can easily lose 20 or even 30 per cent in a year, whereas most bonds rarely lose more than 10 per cent in any one year.

  • Systematic risk: How an asset may respond to risks within the system; that is, how closely correlated the asset is with wider financial assets. If the US economy nosedives, is your asset going to crash in value as well?

  • Volatility: How much the value of a share, bond or commodity varies on a daily basis. For many people, high volatility implies higher potential risk.

Ensuring Long-Term Investment Success: Keeping Costs Low

In addition to running focused trades and using well-thought-through strategies, the key to long-term investment success is keeping costs to the absolute minimum. Here are some of the costs to keep in mind:

  • Trading costs: Based on actual dealing, these are of course a hugely important factor.

  • Bid–offer spread cost: Between the buying and selling price of a security this can easily amount to a few per cent (though most liquid investments shouldn’t cost you more than 0.30 per cent).

  • Expressing a particular investment view: For instance, many hedge-fund managers trade in and out of exchange-traded funds, which incur running expenses when tracking a major index. These management fees can amount to as much as 1 per cent per year (although most charge less than 0.50 per cent).

  • Investing directly in hedge funds: Usually done through a mutual fund or unit trust or via a stock market listed vehicle, these actively managed funds charge fees that can easily amount to 2 per cent per year as well as an additional ‘performance fee’ (the trigger for an extra payment can be as little as a few per cent a year).

    Add in the fund fees, include the costs of running your tax wrapper (401k pension fund in the US or self-invested personal pension plan in the UK) and suddenly the total ownership cost is above 3‒4 per cent per year.

    Consider targeting net costs of less than 1 per cent per year, with long-term real returns (before costs) of 6‒8 per cent per year.

Understanding the Life of an Economic Bubble

Economists (or perhaps ‘bubblanalysts’) such as Hyman Minsky and Charles Kindleberger have identified five stages of an economic bubble. Take a look and see how you can identify and utilise these stages in your own investment portfolio:

  1. Displacement. This term simply means that some external shock, surprise or new piece of technology arrives that creates a whole bundle of new profitable opportunities. The dot.com bubble of the 1990s was a displacement as the Internet opened people’s eyes to the possibility of huge, global transformations in which entire industries may die and new business champions arise. From 2001 to 2008 the displacement involved a massive housing boom and the emergence of cheap, easy-to-access credit from large international banks.

  2. Credit creation. The initial phase of displacement creates an enormous boom and large amounts of capital flood into the sector. As those profit-making opportunities become more common, banks and credit institutions sense that they can make money and they offer loan and credit facilities to all and sundry: from hedge funds through syndicated loan facilities to huge private-equity houses that scramble to buy the best companies. Eventually demand for a particular asset outstrips supply, at which point all the money chasing a diminishing number of opportunities creates a massive increase in prices.

  3. Euphoria. The technical term for euphoria is momentum. Eventually all this enthusiasm for a company, sector or theme gets out of hand and the prices of shares keep trending upwards, hitting new highs. Debts start to pile up among those feverishly optimistic investors, helped by the promise of ever-increasing underlying asset prices.

  4. Financial distress. What follows is inevitable. Insiders cash in, sell shares and take profits. Banks start to worry about the risks and the share price of great growth stocks wobbles. Companies loaded to the gunnels with debt now find themselves in financial distress and the credit tap is firmly switched off. Frauds also become obvious as the tide turns against the sector: fictitious businesses suddenly find their cash flows dwindling to next to nothing. Mayhem breaks out and prices start to collapse.

  5. Revulsion. After the event, everyone admits that of course they knew secretly the situation was a sham all along. Credit is stopped, and sellers are forced to sell their rapidly devaluing assets into a market that’s choked with too much supply and barely any demand. Prices collapse and eventually everyone says that they’ll never go near these kinds of assets again. A stage of revulsion is reached and the share price of what’s now an ‘ex’ growth stock collapses. Eventually everyone moves on to the next big thing and prices flat line for many months if not years. Savvy investors say that everyone else has capitulated and then . . . quietly start buying again!

Balancing Risk and Age: Lifecycle Investing

Your age impacts heavily on the type of investments you need to be making. Over your lifetime as an investor, your appetite for risk (and return) evolves. As your tolerance of risk changes, so too does your choice of assets. The same investment product can look completely different to investors of different ages - as these helpful bullets explain:

  • As a young investor: Imagine that you’re 20 years old and have just landed a great job working for a large multinational. You’re earning enough money to put aside £100 a month in a fund that you plan to stick with for the next 40 years of your working life, but for now you want lots and lots of growth in your underlying investments. Therefore you’re willing to take on some risk now, and the long-term data on returns suggest that the riskiest, most rewarding of the major asset classes are shares.

    Bonds, by contrast, are a bit boring and safe; although you probably won’t lose more than 20 per cent in any one year (called your maximum drawdown), equally you’re never going to bag anything that makes your fortune. In summary, as a thrusting young buck you quite sensibly decide that your risk tolerance is high and that you want to stack up on equity exposure and ‘go for it’ in terms of risk.

  • As an investor nearing retirement: You’re now a considerably older 60 year old. Retirement is only about five years away, and so you need to accumulate a large pot of savings capital to last you through to your twilight years (you may well live until you’re 90 if current longevity studies are right). Therefore, capital preservation is all-important to you. You absolutely can’t afford a capital loss or drawdown of something like 20 per cent in one year – and so you have a very negative view of shares and are a very big fan of bonds.

  • As a retired investor: Curiously, when the typical investor retires, the consensus on the ‘correct’ investment balance becomes a little muddier. On paper, retirees should be ultra cautious – they have to preserve their pension pot for a retirement that may last 30 or more years. But they also require an income to live on and the assets with the safest profile – bonds and government bonds or gilts – tend to pay the lowest yield.

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