ISA quiz: Risk versus reward
28th March 2013 17:11
It is tempting to approach all investment as a race to accumulate the greatest possible return in the shortest possible amount of time.
This may work for a lucky few, but for most investors it means taking far too much risk and feeling every bump of the market cycle. To accumulate wealth over the long term, investment should be a balance between risk and reward.
Before you decide on where to put this year's stocks and shares ISA allowance, you need to start by looking at what you want to achieve from your investment. This requires an honest appraisal of how much risk you can afford to take, both financially and emotionally. It's no use buying the hottest technology fund if the prospect of losing any capital has you burying valuables in the back garden. Equally, if you're an adrenalin junkie with money and time on your side, cash savings might not be for you.
This quiz will help you decide your attitude to risk and guide you to the right fund for this year's ISA allowance:
1) When do you need the cash from any investments?
a. Within the next year, b. Within five to 10 years, c. I can leave it for more than 10 years
2) What does your existing portfolio look like?
a. 100% equities, b. 50/50 bonds and equities, c. All cash
3) What is your age?
a. Below 40, b. 50-65, c. 65+
4) What would happen if you lost 30% of your investment in one year?
a. You would have to sell your house/pets/granny, b. You would have to make some small adjustments, but it definitely wouldn't affect your long-term plans, c. You would shrug your shoulders and hope for a better year next year
5) Are you more troubled by the prospect of missing out on a gain of 20% or losing 10% of your investment?
a. Losing 10%, b. Equally bad, c. Missing out on a gain
6) Imagine you were in a job where you could choose whether to be paid salary, commission or a mix of both. Which would you pick?
a. Salary, b. Both, c. Commission
7) Do you believe that an active approach - whereby fund managers pick companies for a portfolio, rather than simply replicate an index such as the FTSE 100 - can add value?
a. Yes, b. No, c. Don't know
8) Do you need an income? Are you investing for school fees, for example, or care home fees, or just for general living expenses?
a. Need income, b. Need small income, c. Only looking for capital growth
9) Are you happy to buy an asset class, such as equities that has been out-of-favour?
a. Yes, b. Possibly, c. No
Scores:
1) a.0 b.5 c.10; 2) a.10 b.5 c.0; 3) a.10 b.5 c.0; 4) a.0 b.5 c.10; 5) a.0 b.5 c.10; 6) a.0 b.5 c.10; 7) a.10 b.0 c.5; 8) a.0 b.5 c.10; 9) a.10 b.5 c.0.
0 to 30 points - Low-risk investor
You're a comfy slippers kind of investor. You don't want too many surprises from your money and, with that in mind, you should probably limit yourself to solid cash and corporate bond investments, perhaps with a tiny sprinkling of equity income on the side if you are young.
30 to 60 points - Medium-risk investor
You're not inherently a gambler, but perhaps you bungee-jumped once on holiday. As long as the core of your portfolio remains intact, you can take a bit of risk around the edges. Perhaps a predominantly bond and equity income portfolio with some racier emerging markets thrown in for some extra excitement would suit you.
60 to 90 points - Higher-risk investor
You're a Cresta Run type of investor, believing a little bit of fear could be worth it for the chance of some chunky gains and an adrenalin rush. You probably have a decent amount of money and can afford to take a long-term view. You might naturally be looking at emerging markets and smaller companies, with perhaps some high-yield bond funds for balance.
Your ISA decision also needs to take into account market conditions. This year's risky asset may not be next year's risky asset. For example, although bonds are traditionally thought of as 'low-risk' assets, particularly government bonds, they are drawing to the end of a decade-long bull run, and there is a real danger investors could see capital losses. Investors in gilt funds, for example, have seen the value of their investments fall by 1.7% since the start of 2013 - perhaps not what they had expected from a 'low-risk' asset.
Capacity for loss
If you're young, with few dependants, and your idea of luxury is a pint of beer and a packet of crisps, you can afford to ride out the market's ups and downs in the hope it will work out in the long run.
Alex Morris, managing partner at Financial Relationships, says: "If you are young and looking to invest for the longer term - longer term generally means 25 years - then you should be willing to accept more risk. Yes, the portfolio may go up and down, but in the longer term should head in a positive direction and, should you experience any losses, you have sufficient time to recover and benefit from pound-cost averaging."
If you are older, you have less time to ride out market volatility. Equally, if you have children or elderly relatives depending on you, you would be ill advised to take too much risk with your investments. Morris adds: "If you are looking to retire shortly and your investment will make a significant contribution to your income, then your risk profile should decrease because you wouldn't want to risk the golden egg so near to retirement."
Of course, any decision should also take into consideration your existing portfolio. Investors should work on the basis that a low-risk portfolio tends to combine a number of different asset classes, so that if one goes down, the others will support overall returns. If you are already up to the eyeballs in corporate bonds, it is a whole lot more risky to keep buying more than to diversify with an equity fund, regardless of the risk profile of the individual asset.
The risk you want to take
This is a hard one to judge. The fact that you enjoy rock-climbing or sky-diving does not necessarily mean you want to take risk with your investments. It may also depend on the type of job you do. Alistair Cunningham, a financial planner at Wingate Financial Planning, says he recently dealt with a wealthy painter and decorator. He could afford to take plenty of risk, but was used to a cash business and would have been very uncomfortable with the idea of losing money on the stockmarkets.
Ultimately, it is about balance. Morris says: "What risk of financial loss would you be willing to accept for a given return? For example, if you think UK equities will rise by 10% over 2013, what are the potential risks and how much pain would you be willing to accept to make that return? There is always a risk that markets could tumble - so how far would you be willing to accept a loss to take before you get out? If we were to say 5% and you invested £10,000, you are aiming to make a £1,000 return but are willing to make a financial loss of £500 in the process.
Don't take more risk than necessary. It is easy to chase returns from 'hot' areas, such as emerging markets, but if you don't need to take the risk, why risk losing your cash?
Market conditions
This is a harder one to judge and picking the correct asset at the correct time is something that eludes even the most experienced investors. Government bonds are currently the best example of how the relative 'riskiness' of an asset class can change over time. Gilts may have looked good value when they paid more than 10% a year as recently as the early 1990s, but it is difficult to make the same case now they pay just 2%.
Robert Forbes, a financial planner at Plutus Wealth, says: "One of my biggest bugbears is that people tend to see risk purely in terms of volatility, in other words the extent to which the price moves about. Therefore, government bonds look low risk because they have historically had low volatility, but this doesn't mean they are less likely to drop off a cliff in future."
Forbes always ensures that his clients' portfolios are dynamic and can move about to suit different market conditions. The group uses a relatively small (20) range of investment funds and moves them around to accommodate different clients and risk environments. That said, he is wary of shifting portfolios around too much - "nothing ever changes that quickly", he adds.
The aim of any investor should be to buy low and sell high. It is a harder trick to pull off than it might seem, but it means keeping a close watch on the value of different asset classes. For example, at the moment, bonds have had a strong run for 10 years and therefore look expensive. Equities, on the other hand, have spent a long time out-of-favour with investors and may therefore offer more value. It is easy to get caught up in the complexities of investment markets, but it's all about the price you pay.
Active versus passive
There is also the active versus passive decision. Active is where a manager decides when to buy and sell funds whereas passive means funds track an index. Cunningham says: "Passive is unquestionably the lowest-cost option, and cost is one predictable area of investment returns. That said, some of our clients like to take an active approach, believing that some managers can add a lot of value to a portfolio."
So how does that translate into a portfolio? The answer is, unfortunately, not that simple. Portfolios are individual to every investor. Received wisdom is that if you are low risk, you invest in developed market government bonds, such as those of the UK, US or Germany; medium-risk investors might dip a toe into higher-income equities; and higher-risk investors would be looking at emerging markets or smaller companies. Those principles have been shifted by the changing risk profile of government bonds, which may be best avoided at this point in time, but in principle the same basic rules apply, and our quiz should lead you to one of three categories listed in the box above.
Fund recommendations
Darius McDermott, managing director, Chelsea Financial Services, recommends:
Low-risk investors:
"A multi-asset fund that gives a good spread of investments with some diversification across multiple asset classes. Historically, it has given steady returns with quite low volatility."
Medium-risk investors:
"This fund concentrates on companies that increase their dividends year on year. It gives global diversification with a good spread across the globe. Invested companies tend to be more mature and defensive."
Higher-risk investors:
"A stockpicking fund looking for growth around the globe. Reasonably concentrated, high conviction with mid- and small-cap bias."
Gavin Haynes, investment director, Whitechurch Securities, recommends:
Low-risk investors:
"A good option for cautious investors worried about the real value of their funds being eroded by inflation."
Medium-risk investors:
"Dividend-yielding shares continue to offer potential for an attractive total return through income plus capital growth. Adrian Frost has managed this fund since January 2002, and aims to be pragmatic, modifying his investment style to suit investment conditions as they change over time."
Higher-risk investors:
"Despite a strong year in 2012, I continue to see opportunities in UK Smaller Companies. Increased M&A activity could boost returns if business confidence improves. Paul Marriage is a manager who has proven to be one of the best stockpickers in recent years."
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