Investors must make tough decisions about asset allocations, and how they will buy their investments
IF YOU are investing into stocks and shares individual savings accounts (Isas), you will already be aware of the long-term benefits of investing. But many still do not realise that portfolios need to be balanced across different asset classes too.
Asset allocation is the bedrock of successful investing. Influential research by Gary Brinson, L.R. Hood and Gilbert Beebower has shown that it can reduce the volatility of a portfolio. While this means that you are unlikely to achieve nose-bleed returns, it will make returns more stable.
Some, like legendary investor Benjamin Graham, estimate that you could annually beat inflation by up to 5 per cent via superior asset allocation. And James Bateman of Fidelity agrees, pointing out that a diversified portfolio will “help to provide better returns, at a lower risk, over the long-term”.
IT’S ALL ABOUT YOU
The challenge for investors lies in deciding exactly how much to allocate to each asset class. So the first step in portfolio construction is to understand your own investment goals.
Jason Hollands of Bestinvest suggests that you “take a step back, and think about what your overall strategy is”. Why are you investing? Over what timeframe? And importantly, what is your risk tolerance?
Given the importance of asset allocation, it may be worth seeking financial advice – certainly for inexperienced and less confident investors. An adviser will either charge hourly fees, ranging between £80 and £250 per hour, or a percentage of assets that they manage (or the size of the portfolio they construct), which could be up to 3 per cent. And since research shows that advice can boost the size of your portfolio in the long-term, it may be worth paying.
THE ALLOCATION CONUNDRUM
Once you understand your investment goals and risk tolerance, the challenge lies in deciding how to weight your portfolio. It should have exposure to all of the main assets classes: stocks, bonds, property, commodities and cash.
The Association of Private Client Investment Managers and Stockbrokers (APCIMS) has put together asset allocation models based on different objectives (see graphic). The idea is that those with a lower risk tolerance will overweight in assets offering more certain returns, like cash and bonds. And those less averse to risk, and with longer investment time horizons, might invest in more volatile assets, like shares, that have a higher potential return.
Investor Benjamin Graham said superior allocation could beat inflation by up to 5%.
Once you have figured out your own broad asset allocations, you can choose specific stocks and shares Isas that give you exposure to them. There are many to choose from. Through platforms like Hargreaves Lansdown, you can access over 3,000 types of funds. And specialist providers, like iShares, offer around 500 niche exchange-traded funds.
But it is important not to blindly follow past performance tables. While they can give you an indication of a fund manager’s track record, they are not necessarily indicative of the future.
One example is with government bonds: some question whether they will be able to sustain the stellar performance of recent years. So overweighting in bonds now may be risky.
“The art of successful investing is to buy cheap assets, and cash out when they are expensive,” says Hollands, “yet people often do the exact opposite, and follow the crowd.” He thinks that bonds look expensive at the moment, although they appear towards the top of performance tables. He instead favours US equities.
There are nearly 2,000 funds that can be held within a stocks and shares Isa, according to the Investment Management Association. And websites like FE Trustnet and MoneySupermarket, as well as specific investment platforms, will help you choose from a variety of different funds.
Those not confident picking funds needn’t fear. Trackers, which aim to match the performance of an index or asset class, offer a passive way of building a diversified portfolio with only a few funds (see table).
However, the principles of diversification mean that this minimalist approach is risky. For example, within the shares asset class, you will want exposure to investments that focus on growth as well as dividends. And it is difficult to achieve this through just one fund.
On the other hand, the ease with which we can buy funds now means that investors must be careful: avoid buying too many when structuring your portfolio. They may overlap with each other. Hollands says it’s “more difficult to monitor and it waters down the positive impact of the better funds you hold”. He suggests that a portfolio rarely needs more than 20 funds.
Isa providers like Nutmeg go a step further. Based on information that you enter about your investment goals, it automatically builds a diversified portfolio for you, and it will also re-weight asset allocations on a monthly basis. However, you need to invest a minimum of £1,000 to use the service, and Nutmeg charges an annual management fee up to 1 per cent, in addition to the fund costs (which, it says, are 0.3 per cent on average).
The advent of online investment platforms can make building your portfolio straightforward. But picking funds is just the beginning; equally important is how you choose to buy and monitor these investments.
Isa platforms help by holding your investments in one place. And many providers also provide research to help guide your investment choices.
But with different platforms come different costs. It is, therefore, important to make sure that a platform suits your investment style. For example, if you predominantly pick individual stocks and shares to invest into, Interactive Investor’s platform may be appropriate, because of the competitive dealing fees, which can be as low as £5 per transaction. But those that are more interested in buying funds may prefer platforms that offer discounts on initial charges, like Bestinvest and Hargreaves Lansdown.
Most platforms will also charge a fee to hold stocks and shares Isas. These can range from quarterly charges (Alliance Trust Savings only charges a flat fee of £10 per quarter), or charges based on specific funds (Hargreaves Lansdown’s fee for holding a range of trackers is £2 per month).
These costs can add up. So when you are monitoring your portfolios performance, it is also important to monitor how much you are paying for investing. Tools like Rplan are quite useful for this; not only does it suggest where you can make improvements in your holdings, say by investing in a cheaper fund, it also suggests how you can re-weight your portfolio to achieve better performance – and it does not charge any fees to investors for this service. It is wise to monitor performance periodically – most experts suggest monthly at the very least.
But once you get past picking funds and using platforms, the process is straightforward. Then, all you will need to do is focus on whether your portfolio is achieving your investment goals.