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Keeping an eye on risk

Understanding how you manage risk over time is crucial in building your Sipp portfolio
February 7, 2019

We can skip to step two of the portfolio construction manual as, having decided to invest in a self-invested personal pension (Sipp), the objective is established as being well off in retirement. The next thing is to estimate how much money is enough, based on your anticipated lifestyle, property situation and adjusting for inflation. With a Sipp (unless you trade it in for an annuity) you will continue to accrue investment returns throughout your life, but having a target amount of money for retirement is useful to help you manage your approach to risk as you build the portfolio.

Running a Sipp can be thought of as managing three variables: 1) time, 2) your levels of contributions and 3) risk and return. Investing over a longer time frame and saving more when you’re working reduces the onus on investment performance.

 

What is risk?

Many people might think of investment risk in terms of losing all their money on the stock market. This type of extreme loss is possible, but usually occurs when investors have just bought shares in one company. The risks faced by individual companies or by whole industries can be diversified by investing in a portfolio of shares or collective investment vehicles such as managed funds. It is also possible to buy index trackers where risk essentially becomes the level or rises and falls of the stock market.

Individual companies come and go, but neither the UK nor US stock markets have become worthless in their history. This includes surviving two world wars, the Great Depression and the financial crisis. Therefore, when you think of managing market risk, you should think in terms of periods of market decline, which is the trade-off for a sustained pattern of positive returns in the longer term. As a long-term investor, your risk is how much the value of your portfolio declines from peak to trough in a period of turmoil for asset markets. 

 

Asset allocation – the key to risk-adjusted returns

The way to limit peak-to-trough risk is by diversifying investments across different asset classes, not just buying shares. Not all assets are eligible for inclusion in a Sipp wrapper – for example buy-to-let residential property isn’t allowed – but you could include commodities, cash and commercial property real estate investment trusts (reits).

Having assessed your financial position holistically (working on the assumption that you hold property and plenty of cash outside of your pension savings) the main asset classes for your Sipp should, however, be equities (shares) and bonds. The principle behind a bond is simple, sovereign governments and companies borrow money and issue a bond promising to give a regular payment (the coupon) over the lifetime of the loan before repaying the money. In practice, despite the simplistic concept, bonds are a highly complex asset class. As well as credit risk, bond prices fluctuate on the secondary market due to changing interest rates (coupons are fixed therefore prices must change to offer yields commensurate to rates). The sensitivity of bonds to interest rates is known as duration risk. Given these and other factors, the best way to invest in bonds is through funds.

Historically, there have been periods when the total returns from equities and bonds have been negatively correlated – when shares haven’t done so well, bonds have overcompensated and diverse portfolios continued to make money. The decade between 2000 and 2010 was a great example of this. The annualised real rate of return for global equities was -1.3 per cent in what, thanks to two savage bear markets (in 2000-03 and 2007-09) is considered a ‘lost decade’ for shares. By contrast the annualised rate of return for 10-year US government bonds was 5.9 per cent (figures from the 2018 Credit Suisse Global Returns Yearbook, Dimson, Marsh and Staunton).

Investors cannot, however, rely on past correlations between equities and bonds to provide such a hedge going forward. Following years of exceptional monetary policy (low interest rates and quantitative easing) by central banks in the aftermath of the financial crisis, the equilibrium level for interest rates is very much lower than it was at the end of the 1990s. Prices of the two asset classes are now much more likely to move in the same direction.

 

Think of managing total downside risk, rather than hedging against it

In the current climate, bond funds that are exposed to greater credit and duration risk should not be considered as a hedge against equity market falls, they are risk assets and could be affected adversely by the same economic factors that are bad for shares. Funds that invest in shorter-duration bonds issued by bodies with lower credit risk (such as the US and UK governments), can still dilute the peak-to-trough risk in your portfolio, even if the days where they could significantly offset equity weakness may be at an end. In a sustained sell-off in equities there will be a flight to quality, and assets such as US Treasuries, which have more room for price gains following the Federal Reserve’s rate hiking in 2018, might help prevent your portfolio from losing as much value as the stock market.

The rough target figure that you came up with for the size of your Sipp on retirement is useful in deciding your asset allocation. Taking account of how long you will invest for until retirement and the level of contributions you intend to make can help you work back towards a required rate of return. This can be used in managing the level of risk you take by comparing it with the long-run rate of return from shares, to help give a perspective on what different equity-bond splits would mean for your Sipp.

In terms of bond returns, 10-year government bonds can’t be expected to match their performance of the past 30 years. With interest rates still historically low, it’s better to manage future asset allocations based on how shorter maturity bonds have performed. The annualised real rate of return on US Treasury bills (very low-risk debt with zero to three months until maturity) has been around 1 per cent over the past four decades. If you take this as a benchmark for low-risk returns and see what blend of this and the long-run equity return matches your required rate, then you have a starting point for deciding a strategic asset allocation. It is important to stress, however, that this is an exercise in setting perspective. A young person with a long time until retirement and who is making regular contributions, will need a lower rate of return, but that certainly doesn’t mean they shouldn’t take more risk in their portfolio.

Rather, it is worth looking at the level of peak-to-trough losses different mixes of equities and safe bonds suffered in past bear markets. You should look at how long it took these asset allocations to regain value in recoveries and assess the trade-off between downside risk and the rate of return. The goal of portfolio management is to get the maximum level of return for the minimum amount of risk but the magnitude of peak-to-trough falls you are willing to tolerate depends on your personality and circumstances.

 

Lifestyling, compounding and contributions

You can take more risk when you are younger, so provided you are comfortable, you should pursue a higher rate of return than you need in the early years of your portfolio. If you reinvest gains (especially including dividends), then there is a phenomenal ratchet effect on the value of your portfolio. The earlier you start and the bigger the investment gains and contributions, the less risk you’ll need to achieve your target portfolio size as you get older.

As you move through life, you can reassess the risk you are taking and adjust your strategic asset allocation accordingly – moving out of equities and into safer assets. This is known as lifestyling and is particularly useful for investors purchasing an annuity, as it locks in gains. For Sipp investors, who are maintaining their investment portfolio throughout their life, then there won’t be any desire to miss out on equity returns. 

Overall, the benefit of asset allocation is that it allows you better control over the level of risk in your portfolio than had you invested in shares alone. It also removes the uncertainty of trying to time markets. Often the biggest gains from shares are to be had in the early stages of bull markets, which investors miss out on by sitting on the sidelines for too long. If you feel comfortable with your risk levels, you can maintain a position during bear markets confident you will catch the upsurge in the recovery.

 

Benchmarking and tactical asset allocation

With the general level of risk in your portfolio set by the strategic asset allocation (SAA), investors have the option of just passively investing in their Sipp and reviewing the SAA at various lifestyle stages, when they are closer to retirement or when they might want to vary contributions. More active investors will look to make tactical tilts, when they think the risk-reward profile of different investments are more skewed to the upside. For example, when equities are expensive relative to the past or company earnings growth is slackening, it may be time to temporarily scale back allocation to shares.

Within asset classes, you may want to tilt towards different regions or styles of investing. For example, you may feel that markets have a high degree of momentum, so you would rather invest in growth stocks. Or if Japanese stocks are rated more cheaply on forward earnings potential than US stocks, then you might wish for your portfolio to have a higher allocation towards this region.

When we talk about style or geographical ‘tilts’ we mean versus a market capitalisation-weighted benchmark. If, for example, your portfolio has a simple strategic asset allocation 60:40 global equities to short-duration UK government bonds, an appropriate benchmark for your portfolio is a composite of the MSCI World equities index and the iBoxx UK Government Bonds index.

Just focusing on the equities allocation for now, the MSCI World is weighted towards the biggest companies by market capitalisation, which means about half of it is allocated towards US companies. If you felt that the US market was expensive and therefore likely to deliver a lower forward rate of return, you might want to tilt your portfolio towards other regions by investing in funds with a different geographical allocation. The benchmark can help you measure how well your choices have worked compared with if you had just kept things as they were.

Find out more about Sipps with our special guide:

The road to a perfect pension

How to manage your Sipp

Choosing your provider

Keeping an eye on risk

Countdown to retirement