Options for the lower risk investor
Although younger investors often have the time to ride out short term volatility many still want a lower risk portfolio. They may be taking a first tentative move away from cash savings, be saving for their first home or just not be quite ready to see the value of their limited savings bounce around.
However, building a low risk portfolio is not as easy as it used to be. Traditionally, investors would look to a portfolio of government bonds and cash. But as interest rates have fallen, the returns on savings accounts and bonds have dropped to near-zero and are unlikely to beat inflation. This means the real value of a portfolio invested in cash is falling over time and will gradually buy you less in the real world.
As such, while the temptation is to invest in a portfolio of low volatility investments, it may not be the best way to build wealth in the current environment. Young investors need to think carefully about what a low risk portfolio means to them, and how to build one in a low interest rate world.
Defining a low risk approach
The first step in any investment journey is to define your financial objectives. The concept of investment risk follows from this - it is simply the chance that your investments do not meet your defined financial goals. In this way investment risk means different things to different investors, and concepts of a low risk portfolio will change accordingly.
For example, an investor who is planning on using their portfolio for a property purchase in 5 years’ time is primarily concerned with short term volatility. If the value of their portfolio fluctuates prior to their property purchase they may lock in losses when they withdraw funds. In contrast, an investor saving for retirement is primarily concerned with the expected value of their portfolio in 20- or 30-years’ time. In this way their primary risk is not volatility, instead their concerned about generate long term returns above inflation. A low risk portfolio would mean very different things to these two investors.
As such risk is a complex topic, and there are other aspects to ‘investment risk’ than simply the bumpiness of the ride.
What might a low risk portfolio look like?
Our approach to low risk recognizes that low risk means different things to different clients, it’s a subjective concept rather than a financial fact. When we build low risk portfolios, we always think about two things:
We look beyond bonds alone, reflecting their extremely low returns. We incorporate ‘alternative investments’ such as gold, hedge funds and infrastructure, which can provide an important ballast to portfolios. We also look at economic change and ensure that we hold investments that can survive difficult economic conditions - businesses with good balance sheets, high quality management teams, and products with sustainable demand. Buying into businesses that are not strong enough to survive a recession is an easy way to lose money.
We also build portfolios around what is actually low risk for the client. If a client has long-term horizons, we want to build a portfolio that will beat inflation over that period. If a client has shorter time horizons, we want to build a portfolio that avoids significant short-term losses – such as those seen around the Covid-19 outbreak. We always try to think about what the client needs from their portfolio and build from there, as a result we always try to understand our clients as well as possible.
There is no one-size-fits-all solution to a low risk portfolio, with all investments carrying risks. The right blend of assets today may not be the right blend tomorrow. As such, it is vitally important to take a nuanced and bespoke approach that takes account of changing market conditions and your changing needs.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.