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After considering all these common mistakes, how should one approach investment? I thought you’d never ask! MPT is about blending different assets together, like shares, property, bonds, cash and commodities in a way that gives you the best possible returns for your chosen level of risk. Research has shown that with an efficient portfolio, you can get better returns for any given level of risk, or get the same returns by taking less risk, when compared to an inefficient portfolio. This approach is known as your asset allocation.
In more recent years, MPT has received some criticism, because it is only a backwards-looking approach—that is, it looks at the historical data of how different asset classes react in different situations, and suggests an appropriate split for any given level of risk that can be applied to the future. So one key drawback is that we know the future won’t be the same as the past. We also know that there are certain factors that will influence the returns of different asset classes based on what we do know today.
When this strategy is applied correctly, you are likely to see more steady returns. You can also start to model the likely returns from a portfolio more accurately. This makes the Lifetime Cash Flow Forecasting even more powerful. With these two tools combined, you can more accurately project what you are likely to have in the future, and whether it will be insufficient, too much or just about right.
The question you are probably asking now is, ‘What is the best asset allocation?’ There is no straightforward answer to that question. We use over 100 different combinations for our clients, because it depends on the level of risk they are willing to take, the time they will be investing for and the reason for investing.
I have read books where they have suggested portfolios that will work in all situations. Whilst I can find you portfolios that look amazing today, I would not suggest you invest in them today, because the ‘known knowns’, like interest rates, are at an all-time low.
Given that interest rates are at an all-time low, we are more likely to see much poorer performance from bonds in the future. Don’t be sucked into thinking that a fund or strategy featuring bonds is set for a perfect future either!
Whilst asset allocation is probably the most important investment decision you will need to make, no one decision will be right forever; your strategy needs to evolve with you and the economic environment over time. It needs to be continually reviewed and revisited to ensure it is positioned for the ‘known knowns’.
In the process of saving for your retirement, you may have heard of a term called ‘Pound Cost Averaging’. When you invest regularly (for example, monthly), as the markets rise and fall, these fluctuations have the potential to improve your returns. Let’s look at an example to see why. Tom is looking to invest £100 per month, and his adviser gives him two choices:
‘Investment A’, where the investment steadily rises:
Or ‘Investment B’, where the investment falls and then returns to its previous level:
Tom, being a smart cookie, decides on ‘Investment A’ as his preferred route. After three months, his £300 has risen quite nicely to a steady £327. Not a bad return, he says to himself, but being an inquisitive fellow, he asks his adviser how much his money would be worth had he chosen ‘Investment B’. Instead of £327, he would have now had £400. How can that work when the share is only worth the same amount as it started at? It is because when the prices fall to 50p, he buys double the amount of shares he did the month before, and when they rise back, he benefits from this rise. This is known as
Pound Cost Averaging.
It is also possible to exaggerate this effect through ‘Value Cost Averaging’. It works in the same way as Pound Cost Averaging, with one exception: As the investment falls in value, the monthly amount you are saving should increase, and as the price rises, the amount should decrease.
In other words, when investing regularly, a bumpier market actually enhances your returns; therefore, taking on more risk whilst saving towards a goal can make a lot of sense.
Pound Cost Ravaging!
These principles may seem more relevant to those people preretirement, as we are talking about saving money on a monthly basis, which generally ceases at retirement. However, these principles are just as relevant for people post retirement because they work in reverse when you are drawing an income. As you draw an income, if you take out the £100 a month at the point at where the market falls sharply, you lose a much larger chunk of the investment that is not recovered when the market rises again, because there is less money invested to benefit. As a result, during pre-retirement it is usually worth taking more investment risk, but post retirement in drawdown, it probably makes sense to take less risk, otherwise, you risk suffering from ‘Pound Cost Ravaging’!
The previous explanation assumes that you are going to remain invested post retirement and use a drawdown method. Of course, the situation would be different if you were buying an annuity. You would have no investment risk post retirement, but you would have to approach retirement differently from an investment point of view.
Whereas retirees remaining invested through drawdown probably won’t reduce their risk until they actually start drawing their income, those buying an annuity should reduce their risk
gradually in the years leading up to retirement. Whilst this means they will sacrifice some of their returns, they do not want the value of the returns to be at the bottom of the market and should therefore gradually reduce their risk in the years leading up to retirement.
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