Risk and Reward
Investing needs a hard headed appreciation of what you’re trying to achieve and your appetite for volatility
Article by Tom Anderson
When it comes to planning your investment future, you will want to identify what you are trying to achieve, when you want to achieve it by, and the risk you are willing to take to get there.
An investor needs to be aware that no returns are guaranteed – markets can go down, inflation could make things more expensive and governments will definitely tax whatever they can – and each of these do influence returns in the real world.
However, anything to do with the future requires some assumptions and simplifying the variables is the only way to give a fighting chance of getting a recognisable result. Therefore, the following examples assume that after costs, your investments will grow steadily each year and that there is no inflation, no tax and no withdrawals.
Given these caveats, you might have £10,000 cash that you can invest, and you can afford to add £1,000 each month. If this were to grow at 3 per cent without interruption, after 10 years your portfolio would be valued at about £150,000. If this were to keep growing at 3 per cent, this would allow you to withdraw £4,500 each year without dipping into the capital.
As another example, let’s say you are 35 years old, and reckon that you need a pre-tax income of £30,000 at today’s prices (ignoring any inflation) to retire on at the age of 65. You would need your £10,000 initial contribution, and your monthly £1,000, to grow at 4 per cent above inflation every year.
Given that cash in the bank is earning very little interest, this 4 per cent return is easier said than done but with a long timeframe, you could look at other investment ideas such as shares, bonds or property. However, attempting to generate a higher return will come with a higher risk which means that the value of what you own may go down, sometimes quite sharply.
Or, look at it from the other direction. Let’s say that you have won the lottery or you’ve come into some cash so you now have a lump sum of £1 million and you are wondering what sort of returns you might get from this. If you leave as cash, interest is unlikely to be much more than one per cent, so £10,000 each year. You could buy government bonds, but at current prices these aren’t going to offer more than 2 – 3 per cent per year, so maybe £25,000. These returns are unlikely to cover inflation so the next step up the risk ladder is lending to companies. Corporate bonds are riskier than lending to governments so you could possibly get a 3 – 5 per cent return.
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Buying shares can be a bumpy ride but they have traditionally offered a better return, say 4-6 per cent each year so you could take out around £50,000 from your portfolio without touching the capital. However, there is a commensurate volatility in equities that can be unpalatable, especially if you have a relatively short timeframe (below five years). Property probably generates the same amount but you are looking at a very large, single entity that cannot be easily divided up and that will require a large amount of debt to purchase.
If someone is looking to build an investment portfolio, I usually suggest a range of ideas to try to alleviate volatility whilst still having the potential to reach whatever their personal investment goals and return requirements might be. This could include equity, bonds, property, commodities and alternatives but the mix can be very subjective and personal. It also needs to be held in the right structure to be as tax-efficient as possible.
Therefore, it’s vital to get the risk/reward balance right but all these suggestions make big assumptions about investment returns, inflation expectations, taxation, risk profiles, portfolio charges and advisory costs. Each one of these will vary depending on the individual so you may want to consider getting professional advice when it comes to planning, building and managing a personal investment portfolio.
Tom is a chartered MCSI, FCA regulated investment advisor