Risk, Returns and Optimising Performance

First, understand your own attitude to investment risk. When you measure risks and returns, please remember they are affected by a number of factors, including equity and bond returns, currency movements, interest rates, inflation and taxes.

Consider your risk profile in the range of 0 to 100, where 100 = all equities and 0 = all cash or bonds; so, for example, 60 = 60% equities and 40% cash or bonds. 

Your risk profile is a personal choice. Typically, younger people favour higher risk and more in equities. Those in a position to risk more may have a higher allocation to equities. A good rule of thumb is to have at least five years of your typical expenditure held in cash or near liquid investments.

Investments cover a range of assets, including shares (equities), bonds, private equity, property, art, wine and other investables, and cash (count mortgages and other debt as negative cash, and interest paid on them as negative income).

It’s important to analyse your equity investments by sector (for instance technology, pharma, energy, mining, finance, retail, etc) and by country/geographical area. In particular, you need to be aware of home country bias (holding a large part of your portfolio in domestic shares compared with the benchmark).

What about fees? These come in many forms, including wealth manager/adviser fees, platform fees, fund fees and transaction fees. The folk at financial advisory firm Y Tree, who have done the research, tell me that all-in costs of 3.5% a year are not unusual. Most wealth managers charge more than 2% when you include all their costs. 

Performance evaluation

You should use a benchmark that reflects your risk profile. And you should ensure that your performance data is net of all fees. Too often there are fees that are not readily obvious, transaction costs being one example. 

Many DIY investors use well-known benchmarks such as the FTSE 100 index, but this is incorrect. If your risk profile is 60, for example, it would be more appropriate to use a 60/40 blend of the MSCI Global Index and the Bloomberg Global Aggregate bond Index (GBP Hedged). Importantly, the FTSE 100 omits dividends, so it’s more useful to use a performance benchmark that includes them. 

Avoidable risks 

The following can quite easily be avoided, thereby enhancing your returns:

1. High fees for average performance. Passive trackers that mirror global indices or major indices such as the S&P 500 have annual fees of only around 0.1%. Make maximum use of these. Carefully evaluate any wealth manager/adviser fees.
2. Lack of diversification, in particular home country bias. Sector bias also increases risk. You should also beware of having a large number of active funds which effectively mirror the index, rather than using an index tracker with much lower fees.
3. Trying to time the market. Research shows that much of the returns that follow a bear market are generated in the early period following the low point of the market, and that it is a mug’s game to try and guess when this will occur. It is therefore best to remain fully invested in the market. Excess cash is an avoidable risk.
4. Not accessing the illiquidity premium of private equity. Historically private equity has outperformed the global stock market. The logic is that you have to invest for a long period if you invest in private equity, so investors should expect a higher return for not being able to sell their shares until a liquidity event occurs. Private equity funds typically require investors to invest a minimum of £5 million plus. However, there are a number of quoted Private Equity funds through which ordinary retail investors can get access to the illiquidity premium of PE.
5. Not buying investment trusts that are trading at a discount. Investment trusts generally trade at a discount to their net asset value (NAV) and much less often at a premium. Currently there are many trusts trading at a discount, some quite significant. Some of these may be a reflection of a disconnect between share price and NAV, as their NAVs are only updated at interim and final accounts. However, there is an argument that the investment trust sector is out of favour, and that when sentiment improves (it could be years) the share price will increase as investors return to the market, providing an added kick to returns. This requires taking a long-term view.
6. Trying to pick winning shares. You cannot beat the experts. It is their full time job. This rule may be anathema to many ShareSoc members who enjoy the fun of stock-picking, including me. By all means, feel free to have a small proportion of your investments in your ‘fun’ portfolio, but recognise the risks involved. 
7. Tax. Tax wrappers such as SIPPs and ISAs are highly tax efficient. VCT, EIS, SEIS, etc are other vehicles to consider. Most AIM shares are classified as IHT-free (at present), as are business assets, woodland, etc. Make use of the most appropriate options for your portfolio. 

In summary, there are various basic steps you can take to help optimise the performance of your portfolio. They are not rocket science, but should help to make it more robust and sustainable over the long term – and less likely to keep you awake when markets are choppy. 

Cliff Weight, ShareSoc member