The single biggest risk to your retirement
If you've entrusted your wealth to a financial adviser, it could be exposed to very high risks, says Bengt Saelensminde. Here he explains how, by allocating your assets sensibly, you can reduce your risk and keep the rewards to yourself.
I've got an awful lot to say today, so hold on tight.
It's one of those subjects that gets me hot under the collar. Many financial advisers give so much duff advice on this subject that it really makes me mad.
Yet it's probably the most important thing you need to get right to ensure your savings deliver the retirement you're expecting. That's why I've been going on about asset allocationrecently. Today I want to run through how you can get it right.
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Believe it or not, there are a few simple steps you can take to reduce risk, without giving up any rewards. This is far too important to leave up to an adviser; I can guarantee you that only you have the knowhow required.
Have you forgotten something important?
Asset allocationis just a technical term for how your savings are split between different asset classes (shares, bonds, cash, etc).
First off, we need to get a grip on what your savings are. What counts as'savings'? The three main categories are equity, bonds and cash. But you can count in all your property, as well as alternatives (wine, antiques, gold, stamps, etc) if you plan to use them as part of your long-term savings plan.
In my experience, advisers often overlook these assets. They tend to think aboutasset allocationjust in terms of traditional financial investments. It's easier for them that way. But I want you to think about all your wealth. I want you to include anything that you are likely to cash in to fund your retirement. If you don't look at the whole picture, you may be missing something vital.
Let me explain with an example.
How your retirement plan could be exposed
I wouldn't normally include a family home, as it's not likely to be sold to finance retirement. But what if you're planning to retire to Tuscany, where you've got a second home? In that case, if you're going to sell the family home to finance the move, then you need to include it in your assessment.
Say you're just a few years away from making the move. An adviser looks at your portfolio (wit hout the property) and says "we need to get your funds out of stocks and into bonds as they're safer. We can't afford to take the risk of shares just now." So that's what you do.
But then, interest rates suddenly shoot up to 6%. Disaster! Bonds would be about the worst place to be in this scenario. Bonds can crash if rates unexpectedly shoot up. Even worse, at the same time, rising rates can crush the housing market. There goes your property asset.
Now, if you'd considered the whole savings plan, you'd have seen that you need diversification to protect against an unexpected rise in rates. But the adviser wouldn't know this. He didn't ask about your plans to sell the house, and he overlooked possibly the biggest asset in your plan! So your entire savings pot was left exposed to a single risk.
Or maybe you're planning on selling a business. Okay, it may be difficult to value, but if you exclude it, you may be missing something important. Suppose it turns out to be 90% of your portfolio! That may be telling you that it's time to start looking for an exit strategy, so you can cash-out and diversify into other asset classes.
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Generally, I'd include everything from pension savings, to ISAs, to cash in the bank (less any loans). I'd then look at what's inside each of these 'wrappers' to get the asset allocation.
You may end up with something that looks a bit like this:
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| Equities | £85k | £25k | Row 0 - Cell 3 | £30k | Row 0 - Cell 5 | £140k | 43% |
| Bonds | £15k | £5k | Row 1 - Cell 3 | £15k | Row 1 - Cell 5 | £35k | 11% |
| Cash | £5k | £5k | £10k | £3k | Row 2 - Cell 5 | £23k | 7% |
| Property | Row 3 - Cell 1 | Row 3 - Cell 2 | Row 3 - Cell 3 | Row 3 - Cell 4 | £130k | £130k | 40% |
| Total | Row 4 - Cell 1 | Row 4 - Cell 2 | Row 4 - Cell 3 | Row 4 - Cell 4 | Row 4 - Cell 5 | £328k | 100% |
Only you are qualified to decide what assets you want to put into yourasset allocationmodel. So have a good think about it. How are you funding yourretirement?
I'd adjust pension savings by taking off the tax that you'll pay when you draw it down. Otherwise you won't be comparing like with like. Take into account all these factors, and you know your asset allocation.
The next thing is to make sure your spread across asset classes is safe.
Watch out! This common advice is downright dangerous
Do you know those questionnaires you get from advisers? They ask you what sort of risk you want in your portfolio. You end up with a risk grade between 1 and 5. Advisers then use your risk rating to choose asset classes for you. It works a little like this:
cash is considered safest, bonds next and then equities most risky. So you adjust weightings in the portfolio according to how much risk the client wants:
| Equities | 85% | 75% | 25% |
| Bonds | 12% | 20% | 50% |
| Cash | 3% | 5% | 25% |
| Row 3 - Cell 0 | 100% | 100% | 100% |
But this can be dangerous. For starters, look at the 'low risk' portfolio. It's got 75% in cash and bonds. But cash and bonds can get hammered by inflation. In some circumstances the 'low risk' version could be catastrophic!
And anyway, as we saw recently, your attitude to risk is constantly changing. If the markets have been doing really well, you're likely to feel like taking on more risk than if they've been doing badly.
It is absolutely essential to diversify across the asset classes. But the true risk/reward balance lies within individual investments. So within your bond allocation, corporate bonds are riskier than gilts (and that's why they pay a higher yield). Within your equity allocation, emerging markets and penny shares are usually more risky, but potentially a higher reward. Cash can be spread into different currencies. If you want to retire to Tuscany, why not buy some euros too?
Never give up on diversification. It will make your portfolio safer. The more asset classes you hold, the better. And in turn, be sure to have a mix of risky and safe investments within those classes. But how do you pare down risk without missing out on great rewards? Believe it or not, there's one simple way.
The bottom line on how to really reduce risk
Ultimately, the riskiness of the assets you hold should be determined by when you need to cash in the investments. Because investments go up and down, you don't want the risk of having to cash them in when they're down. So basically, as you get closer to the day when you need the cash, you should head into less volatile assets.
Don't let them tell you that a 100% cash portfolio is safe. It isn't! Low volatility is what's safe, and that comes from diversification and from carefully selected investments within each asset class.The individual investments are what are going to deliver the returns over the years. That's an ongoing battle. And it's one that we take very seriously here at The Right Side.
This article was first published in the free investment email The Right side. Sign up to TheRightSide here.
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.