How to reduce investment risk

Nationwide has published latest statistics about house prices.

Nationwide has published latest statistics about house prices. - Credit: Archant

Any adviser worth his or her salt will tell you that there's no such beast as the 'perfect portfolio', a one-size-fits-all selection of stocks, bonds and funds designed to satisfy every investment ambition.

The reason, of course, is that individuals have widely differing expectations of how their portfolios will perform over different periods of time. Of even greater significance, however, is our attitude towards risk and the degree to which we're prepared to accept it. At one end of the risk spectrum is the risk-averse investor who either keeps his money under the mattress or invests every penny in Premium Bonds. Such a strategy ignores the corrosive affects of inflation, which gnaw away at cash piles and seriously undermines its future value. At the other is the gung-ho investor prepared to take significant risks by investing in start-ups, emerging markets or cutting-edge technology stocks. There's no harm in buying into any one of these areas (there are many more, equally hazardous, areas of investment), but a portfolio underpinned entirely by risky investments is likely to come a cropper at some point. Most of us are content to have some Premium Bonds buried within our investment portfolio (because we could win the £1 million first prize), together with a smattering of what we acknowledge as riskier funds or shares which, if they come good, could provide a welcome boost to portfolio performance. On the one hand, then, we're prepared to accept the debilitating, longer-term impact of inflation, while on the other, we appreciate too that our investment in an AIM-listed mining firm worth threepence ha'penny could go belly-up. Subconsciously, we know there's little chance of scooping both the top Premium Bond prize and the virtually worthless mining firm, whose shares are quoted in fractions of pennies, uncovering a hitherto unknown seam of gold ore and turning the shares into turbo-charged assets, the value of which multiplies ten-fold. Balancing risk and reward is a poser considered by most investors who invariably conclude that they should spread their risks across a broad spread of securities. Yet if randomly selected, simply having a wide range of potentially volatile investments does not necessarily reduce risk, particularly if any movement in the investment's valuations are positively correlated. In other words, holding a broad mix of investments, be they equities, funds or bonds, doesn't diminish investment risk if their values all move in the same direction, up or down, at the same time. Which brings us onto the concept of asset allocation. Effective asset allocation is determined by establishing the extent to which each element of an investment portfolio has an impact upon its overall, aggregate risk. This is achieved by taking account of how movements in individual asset prices (shares, bonds, funds etc) are correlated with each other. It follows that the type of asset allocation policy employed by investors can have a significant affect upon their portfolio's performance. This much was first established by an academic study written almost three decades ago which found that more than 90 percent of a portfolio's return is determined by asset allocation. A raft of academics have since questioned the accuracy of this percentage, but few have argued with the relative importance of asset allocation. This begs the question: why is it so important? The principal benefit of an effective, well-considered allocation of investment assets is the resultant reduction in overall risk which accrues from its application. This, in turn, offers investors the opportunity to generate higher returns from their portfolios. . The strategy works because different assets have different potential for risk or growth. Equities, for instance, are invariably deemed high-risk, yet they also offer the prospect of impressively high returns. Similarly, bonds and fixed deposits carry lower risk and while the returns on these assets is inevitably lower, their presence in a portfolio can offer welcome stability. Broadly speaking, there are several factors investors should consider when determining how to allocate their portfolio's assets, with the level of risk to which they're prepared to expose their portfolio of particular importance. Establishing an ideal timeframe or 'investment horizon' can be remarkably useful, while investors should also create longer-term financial goals, taking account of their income, ambitions and current financial status. The concept of asset allocation couldn't have kept financial academics busy for thirty years if it could be summed up so succinctly; there is considerably more to it than this, although establishing the level of risk with which an investor is comfortable remains pivotal to its application.