How to manage investment risk

Saving enough money to retire on isn’t easy. If you’re serious about being able to retire comfortably, you’re going to have to save a lot of money. Not only that but the money you stash away will have to grow faster than the cost of living. If you want to have a decent retirement, you need to increase the buying power of your money.

It would be nice if you could just put your money into a savings account every month and forget about it. But in a world of low interest rates, that’s probably not going to be enough.

As an alternative, you could put all your savings into the stockmarket, but as share prices are currently high, that may not be sensible either.

To have a comfortable retirement, you probably need to spread your money across different assets, and you’ll also need to take some risk.

What is risk?

To most people, investment risk is about losing money. That is a real risk, but you also need to consider another risk: volatility – or how much the value of your savings pot moves up and down.

Big gains make us feel good, but big falls – especially ones that occur just before we need our money – can be disastrous. Volatility can also play havoc with our emotions.

If you don’t stay calm, but instead become emotional, you’re more likely to chase things that have already gone up a lot, and sell things that have gone down – a proven route to investment mediocrity, or worse.

Fortunately, there is a way to get decent results while keeping volatility (or risks) manageable. It’s called asset allocation and is arguably one of the most important lessons an investor can learn.

Asset allocation explained

The best way to reduce risk is to spread it across lots of different investments, which is known as diversification. Having all your eggs in one basket by keeping all your money in one particular investment is very risky. You might make a fortune, or you might lose everything.

But with asset allocation, you’ll have lots of eggs in lots of different baskets. Each basket represents a different type of investment that behaves in aslightly different way to the other baskets. These imaginary baskets are made up of investments such as shares, bonds, cash, property, precious metals and commodities.

They produce different investment returns with different amounts of risk (see below), depending on what’s going on in the world. For example, shares and property do well in times of modest inflation; bonds and cash are better for times of recession.

By having some of your money in each basket, you can still achieve reasonable returns while significantly reducing your risk compared, say, to investing all your money in the stockmarket.

The asset-allocation process means you can decide how much you want to have in each basket, depending on how long you are investing for and how much risk you can cope with.

So, a younger investor saving for a long time can afford to have more money in shares because there is enough time for good years to offset bad ones. Conversely, someone close to retirement, or who is risk-averse, would have more money in bonds and cash.

According to a study in 2012 by investment group Vanguard, asset allocation (where you put your money), as opposed to picking individual stocks, is responsible for 88% of a portfolio’s returns over time.

How it works

The table below shows the different returns and risks from various UK assets. Over the last 26 years, shares have delivered the best return for investors, but they’ve also been more risky. That’s because the standard deviation for shares has been higher – share prices have bumped around a lot.

Government bonds, index-linked bonds and property have produced lower returns, but with less risk. Gold – a hedge against really bad things happening – has given low returns, but can serve as a decent form of insurance in times of financial crisis.

Spreading your money across different investments doesn’t always work out but it has a good track record of reducing risk and protecting you from big losses.

Between 1987 and 2013, someone with 50% in shares, 20% in gilts, 15% in index-linked bonds, 10% in property and 5% in gold, who rebalanced every year (buying and selling assets to get back to the target allocation), would have had annual returns of 9%.

That’s almost the same as an all-share portfolio, but with a much lower risk (standard deviation) of 9.4%. Between 2000 and 2013, this approach would have beaten shares and inflation with lower risk as well.

How to do it

You could buy one of the professionally managed multi-asset funds out there. The problem with these is that they tend to have high charges. Nor are they set up to
cater for individual savers’ needs and risk appetites. The good news is that you can set up your own multi-asset fund very cheaply with exchange-traded funds and index funds.

Investment returns and risks 1987-2013
Investment Returns Risk
Shares 9.3% 16.17%
Government bonds 8.28% 9.7%
Index-linked bonds 4.94% 6.5%
Property 8.69% 10.48%
Gold 4.07% 17.03%