Risk Versus Reward

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So far I have given you an understanding of the different tax wrappers within which you can keep your money. I have then given you an idea of how to plan your future financially. However, this Lifetime Cash Flow Forecast will have to make an assumption about the rate at which your money will grow. Even after planning, your money may not grow as you expect. It is now time to understand how you should invest the money once it is inside these wrappers, in order to obtain the growth to meet your Cash Flow Forecast.

The Eight Investment Mistakes Most People Make

1. The Inflation Trap
2. Timing The Market
3. Selling With ‘Most People’
4. Active Or Passive Funds
5. Property Prices Always Rise
6. Fund Picking And Past Performance
7. Ignoring The Charges And Tax
8. The Liquidity Trap

The Right Investment Strategy

Asset Allocation

After considering all these common mistakes, how should one approach investment? 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 and an appropriate split for any given level of risk that can be applied to the future.

The key to really successful investing through the MPT is to tilt the portfolio towards asset classes that are likely to do better in the known environment and away from those that are likely to do less well.

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. Combining these two tools also allows you to make more informed decisions.

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.

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’.

Pound Cost Averaging

In the process of saving for your retirement, you may have heard of a term called ‘Pound Cost Averaging’. When you invest regularly, as the markets rise and fall, these fluctuations have the potential to improve your returns.

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. 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.

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