Watching the value of your investments plunge over just a few short weeks can be extremely unnerving. Following the longest bull run in history it may be particularly alarming for those who have never invested through a downturn before. While brave investors are spotting value opportunities in the market maelstrom and increasing their equity exposure, financial advisers suggest now is a good time to revisit the fundamentals of your financial plan and make sure you are comfortable with the amount of investment risk in your portfolio.
Basic rules for assessing risk appetite
If you have been investing for a long time, it might be years since you have sat back and thought in depth about what your risk appetite is, and if your asset allocation is appropriate. Identifying your risk tolerance is a tricky task because there are a number of factors you have to consider, but get it wrong and you may end up missing your financial goals, either by taking too much risk or not enough.
To establish your risk tolerance you need to take into account three key elements, says Gabriela Strug, financial planner at Quilter Financial Planning: your need to take risk, your capacity to take risk and your attitude towards risk. Your need to take risk depends on what your financial goals are. For example, if you are saving for your retirement and targeting 5 per cent portfolio growth per year, you will have to place a significant amount of your pot in equities.
Your capacity for loss refers to your ability to suffer losses, but still meet your financial needs. If losing money you have invested would have a serious impact on your personal welfare, you should not invest too much of your portfolio in risky assets. Recent market movements offer a sobering reminder of just how risky investing can be, so you have to be able to take the lows with the highs.
You must also be comfortable with your own personal attitude to risk. “Capacity for risk and tolerance for risk do not necessarily go hand in hand,” says Charles Calkin, financial planner at James Hambro & Partners. If losing large sums of money in market downturns, such as the current one, will cause you an inexorable amount of stress then it may not be worth having a high allocation to equities. However, for any money sitting in cash or some other low-risk asset classes you must accept the likelihood of your capital being eroded by inflation.
While taking too much risk can cause undue anxiety, taking too little can be frustrating for investors over long periods of rising markets. Andrew Mackintosh-Walker, managing director at Close Brothers Asset Management, says if you have a long-term investment horizon and can afford to take risk, “it is hoped market cycles will work over the long term in investors’ favour”.
Your profile may differ for different pots of money, too. An 80-year-old may draw sufficient income from Isas, and be planning to leave their pension to their grandchildren, says Mr Calkin. The Isa pot may be run to a cautious mandate, but the pension more aggressively because it is expected to be some time before it is needed.
Has coronavirus changed my risk appetite?
Coronavirus is one of many crises that have affected financial markets over the years and should not affect someone’s investment approach unless their personal circumstances change, says Mr Mackintosh-Walker. “Investing should always be put in a long-term framework and this crisis will pass like all the others,” he says.
However, if you have lost your job over the course of the crisis, or your health has been impaired, then your income is likely to be affected and this will have a knock-on effect on the level of risk you can afford to take, or you are willing to take. “We should be mindful that being made redundant or being furloughed by an employer could, understandably, result in a change in an individual’s risk appetite in the current environment,” says Neil Moles, chief executive officer at advice firm Progeny.
Even if your risk appetite has not changed, you might decide to alter your asset allocation to weather the storm, notes Mr Calkin. His firm reduced clients' exposure to equities and altered the selection of stocks still held.
Evangelos Assimakos, investment director at Rathbones, says the market fall has brought into sharp focus the need to have sufficient liquid reserves to lean on at a time of emergency. The benefits of diversification across asset classes have also become more apparent, especially for investors who rely on income from their portfolio and can avoid selling stocks at depressed valuations, but raise necessary cash from those that have held up better or even risen in value.
If you are investing for income, youare likely to see a substantial reduction in what you earn from your equity portfolio this year as companies have cut dividends across the board. Dividend futures are forecasting a 50 per cent drop in income from large UK companies over the coming year, and it is not yet clear if they will resume in 2021. If you are reliant on this income, you have to consider how to make up the shortfall to maintain your standard of living. Mr Mackintosh-Walker suggests this might include drawing from your cash reserves to top up your income or increasing your exposure to companies that are going to be able to maintain their dividends through this crisis.
What should my asset allocation look like?
When you are comfortable with your risk tolerance, you need to make sure the asset allocation in your portfolio reflects this.
Generally speaking, the longer the time horizon and the higher the risk appetite, the higher the weighting to equities you should have in your portfolio. In the long run, they tend to give a better return than cash and fixed income. Research in the Credit Suisse Global Investment Returns Yearbook (Dimson, Marsh and Staunton) shows that in the UK, adjusted for inflation, between 1900 and 2019 equities delivered an average annual return of 5.5 per cent compared with 1 per cent for treasury bills. As your time frame shortens and/or your risk appetite lessens, you would look to increase the weighting of less volatile asset classes such as bonds and alternative assets (eg, property, gold, infrastructure and hedge funds) that would improve the risk-adjustedperformance ofyour portfolio.
While you should establish and work within a long-term asset allocation strategy, it should be addressed regularly, on a tactical basis, to reflect changing market conditions and valuations, says Mr Mackintosh-Walker. “This is particularly relevant in times of volatility where an active approach will help to both preserve capital when markets are falling and to take advantage of attractive valuations after markets have fallen.”
You must also make sure that your portfolio is sufficiently diversified. Carla Brown, managing director and financial planner at Oakmere Wealth Management, says sometimes in rising markets clients question why they hold investments such as fixed income funds, which may substantially lag the performance of equity funds. The recent market sell-off has shown why, with a number of fixed income and defensive funds maintaining positive returns and helping to sustain portfolios. Ms Brown says her clients typically hold between nine and 12 funds, spread across geographies and asset classes. She also notes that investors should be careful not to invest in multiple funds with many of the same holdings as they will not achieve much more diversification than if they had a smaller number of funds but will pay more in fees.
Mr Calkin says while all of his portfolios are bespoke, they are managed within four clear risk bands. He conducts risk questionnaires to discern which profile is suitable for every client. A ‘cautious’ portfolio at James Hambro would typically have 40 per cent in equities, 20 per cent in alternatives, 35 per cent in fixed interest and 5 per cent in cash. The second mandate, known as ‘balanced’ allocates 55 per cent to equities, 15 per cent to alternatives, 25 per cent to fixed interest and 5 per cent to cash.
Meanwhile, a ‘steady growth’ investor would have 70 per cent in equities, 10 per cent in alternatives, 15 per cent in fixed interest and 5 per cent in cash and an ‘adventurous’ investor would have 85 per cent in equities and typically no exposure to fixed income.
Whatever your approach to your investments, it is important to have an emergency cash pot. If you are retired and have a secure income (from an annuity or final-salary pension scheme) that might be six months’ income to cover emergencies such as your car needing to be replaced.
If you are in drawdown and dependent on your portfolio for your retirement income, two years’ income might be more sensible. When markets fall you could draw from this cash so that do not have to sell equities when prices are at their lowest.
