First-time investors, a bit like over-exuberant diners in a local curry house, often order the hottest thing on the menu. If you’re tempted to invest by the prospect of high returns, it’s easy to be enticed by the spicy options on offer in, for example, emerging markets.
But just like curry-house novices, investment beginners often live to regret their choices. High returns, after all, come with high risks, so investing is about finding the right mix of assets to hedge your bets and spread risk around.
Which is a bit more complicated than ordering a vindaloo.
So if you want to avoid rookie mistakes and invest sensibly before you lose your £20,000 Isa allowance on 5 April (any amount of which can be used to fund a stocks and shares Isa) the key is to put together a balanced portfolio.
If you invest across a diverse-enough range of assets, you should soften the blow if any one market takes a plunge, although there are no guarantees.
Why asset allocation matters
Different assets behave in different ways and typically carry different levels of risk. Cash savings carry little risk (only that posed by inflation) and correspondingly, little potential gain (a meagre amount of interest).
Next come UK Government bonds, known as gilts. With a gilt, you essentially lend money to the Government, which promises to pay you back your capital plus a set amount of interest over a defined amount of time.
These have traditionally been viewed as having an extremely low default risk, although you could still lose money invested through funds, as prices fluctuate.
Corporate bonds are the third step up for risk and return. These are like gilts except, instead of lending to the Government, you lend to companies.
Then there are company shares, or equities, as they are known. Equities have historically been riskier than gilts and bonds, although there’s a wide-risk spectrum depending on the types of companies and markets you choose.
Finally, there’s property, which can be accessed through commercial property funds and is a bit of a wildcard as the level of risk it carries is hard to quantify.
It’s certainly not low risk – prices and rents go up and down and ‘liquidity’ can be an issue if you want to take your money out quickly. But historical volatility has been lower than that of shares.
Each of these assets moves according to several factors, and not always together.
For example, shares in the UK, US and Europe are strongly correlated, meaning they tend to move up and down together.
On the other hand, UK Government bonds tend to be negatively correlated to shares, meaning they often move in the opposite direction to equity markets – investors often flee to gilts during highly volatile periods in the stock markets.
Corporate bonds have a low correlation with the equity markets, meaning their movements don’t appear connected to the movements of share prices. Some assets are more volatile than others, going up and down more suddenly and dramatically.
One caveat is that quantitative easing (QE) – which involves the Bank of England effectively creating money in order to buy gilts and bonds in order to boost the economy – has pushed up prices to historically unusual levels, leading many analysts to fear crashes in asset prices.
Nevertheless, the idea of using asset allocation (the mix of variously correlated and volatile asset types) to dial risk and potential returns up or down remains sensible and is still used today by most financial advisers.
How to judge your attitude to risk
Deciding on the right mix of assets for you is an art rather than a science. If you use a financial adviser, they will ask you questions about your financial situation and life goals to build up a picture of your “risk profile” – and from there, recommend the best mix for you.
If you’re investing without advice, you’ll need to think about the most you could afford to lose should things go badly wrong, as they did during the financial crash we saw in 2008.
You’ll also need to consider how comfortable you are with your portfolio falling in value – in other words, how much volatility you could tolerate.
Ultimately, whether you use an adviser or go DIY, you are left with the same investment options.
Popular tracker funds
– HSBC FTSE 250 Index
– iShares Emerging Markets Equity Index
– Legal & General European Index
– Legal & General International Index Trust
– Legal & General UK 100 Index Trust
– Legal & General US Index
– Vanguard LifeStrategy 100% Equity
– Vanguard LifeStrategy 80% Equity
Source: Hargreaves Lansdown
And if you want less risk, historical performance data suggests that you should reduce your exposure to equity markets and increase exposure to cash, gilts, bonds and, possibly, property.
So while a typical high-risk portfolio would be 80-100 per cent – or even 100 per cent – in geographically-diversified equities, a more cautious portfolio would limit equities to perhaps 40-50 per cent or50 per cent.
How to create your portfolio
After you’ve decided on your asset allocation comes the challenge of deciding where to actually invest your money. Cheap tracker funds are a good choice. They give you exposure to hundreds more shares and bonds than you could research yourself while keeping costs low.
Tracker funds aim to mirror the performance of their chosen markets, rather than beat them, but they do so cheaply. In contrast, most actively managed funds, which aim to beat the market, fail to do so consistently, partly due to their higher charges.
You can easily invest via an online fund supermarket such as Hargreaves Lansdown, AJ Bell’s Youinvest, Fidelity or Vanguard.
Harry Rose is the editor of Which? Money magazine, and writes a column for i on Wednesdays.
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