Spreading risk is crucial if you want to build a stable portfolio

ONE traditional rule of investing is quite simple. Take your age, subtract it from 100 and invest that percentage of your portfolio in equities and the rest in bonds. When you are young, you have more of your money in stocks, which traditionally perform better over time. As you get older, you move more into bonds, thereby escaping volatility and so insuring yourself against risk when you actually need the money.

Even after decades of financial innovation, that rule still near enough sticks – the most important thing is to understand your personal circumstances and go from there. But there are some things that investors should know about, especially when investing with ETFs.

As Dan Draper, global head of ETFs at Credit Suisse, explains, constructing a portfolio is “a little like building a house”. What makes a house’s design conservative or architecturally outlandish isn’t so much the building materials – though those are of course important. Rather it is how they are arranged. By diversifying, and so buying a mix of assets – bonds, shares and even commodities and more liquid assets like currencies – investors are spread their risk between uncorrelated, or inversely correlated assets. So if one part of the portfolio loses value, then another part may strengthen.

IDEAL BUILDING BLOCKS

According to Draper, ETFs help investors achieve that. “They’re pretty ideal building blocks”, he says. “The great thing about ETFs is that even if you’re just investing your ISA allowance, you can get 6 to 8 funds into that £10,200, so it’s really easy to diversify”.

How you diversify is, of course, also crucial. Unsurprisingly, most older people will want to consider holding more fixed income investments, though with interest rates as low as they currently are, high dividend yield, blue chip equities are also worth considering. Most younger people, conversely, might want to consider more exciting emerging market products so as to cash in on long run growth. Commodities like gold are worth holding in small amounts – about 5 per cent is typical, according to Draper – as a hedge against financial uncertainty, but it is important not to buy heavily into fads.

The important thing is that investors know what their aims are and structure their portfolios accordingly. David Swenson, the chief finance officer at Yale University, achieved returns of 11.8 per cent per year from 1999 to 2009, riding out the recession, by doing just that – his model of investment stressed the importance of choosing several exciting but uncorrelated investments. Investors would do well to follow that advice.

ONCE BALANCED, STAY BALANCED

It is also essential to make sure that your investments remain balanced. If the constituent parts of a portfolio all do very differently, then a fund can get out of line very quickly. Imagine, for example, a fund half in equities and half in bonds. If equity prices increase by 50 per cent, and bond prices halve, the portfolio is now balanced 3:1 in favour of equities.

By rebalancing every year, or even more frequently if you have invested in particularly volatile investments, you effectively take profits in investments that have done well and shore up those that have done badly but might still recover. Over time, that helps you ride out volatility and also, at least according to some, increase your performance. Thanks to their relatively low transaction costs, ETFs make that quite easy to do – meaning that even small investors can build and maintain a well balanced portfolio with an appropriate level of risk.

Investors should also remember to consider all of their assets, including very illiquid ones like houses and life insurance, when building a portfolio. ETFs are best considered as a way to plug holes in a broader life investment plan. Thanks to their liquidity and the range of markets they offer access to, they can be very useful.

Effectively planning for retirement is more than just selling stocks and buying bonds. But with financial markets exceptionally volatile at the moment, having a well balanced and properly managed portfolio is vital.


BUILDING YOUR PORTFOLIO | THE BALANCING POINT

Growth Investors:
Young investors will probably want riskier, more growth oriented assets, because they can afford to endure wealth losses and ride out the peaks and troughs of the market. A typical growth portfolio might include:
70 per cent equities, including some emerging market or new technology funds.
20 per cent fixed income assets such as corporate or government bonds.
10 per cent alternative assets such as commodities or currencies.

Balanced Investors:
As investors grow up, they will probably want to reduce their risk exposure. A more balanced ETF?portfolio could be made up of:
50 per cent equities, divided between riskier growth equities and blue chip firms.
45 per cent fixed income assets.
Five per cent commodities such as gold.

Conservative Investors:
Someone approaching retirement is probably going to be more concerned by volatility than growth, and so will want assets that provide a relatively stable income without risking capital. Such a portfolio might include:
70 per cent fixed income assets.
25 per cent high dividend, stable equities such as blue chips.
5 per cent alternatives.