A question of risk appetite

“I think our income is sufficient for our day-to-day needs, but I may cash in some of our investments to pay for expenses such as holidays,” says John. “So I don’t need the investments to produce income but rather to grow. I would be very happy if they grow 5 per cent a year as this would make up for some of the money taken out for travel.

“We are also going to have some significant expenses in the next couple of years. We are going to contribute £20,000 towards a deposit for a flat for one of our daughters, and spend £15,000 on house improvements. We may also spend £20,000 on a classic car, which I hope will appreciate in value, and there could be weddings to pay for in the near future.

“Because of this, I hold a lot as cash. I could instead invest this and then liquidate it as necessary, but I am very concerned that it could lose value between now and the time when we need it. In the longer term, we need to ensure that we have capital left in case we have to pay for care.

“That said, I think I have too much cash and should invest more of it in exchange traded funds (ETFs). I will move more of the cash into individual savings accounts (Isas) in the next tax year as I have used up this year’s allowance. So what proportion of my assets should be in cash and what proportion should be in risk investments? What types of investments should I put it into? If I invest another £30,000 or more should I invest it in all the ETFs I currently hold, just some of them, or new ones?

“And are my current ETFs satisfactory or could I do better, either replacing individual ones or adding new ones? I am open to putting more into speculative investments, and already hold ETFs focused on robotics and technology.

“But I would say that my attitude to risk is fairly conservative because equity investments can lose money. Before I retired I invested any spare money into cash and funds held in my own and my wife’s Isas.

“Since retiring I have largely invested in ETFs following the suggestion of a work colleague who retired before me and had done a lot of research. I based my portfolio on his. But are there any significant downsides to investing in ETFs? My general aims with my investments are to: 

• Keep costs low, as I do not see the point in paying fund managers who generally cannot outperform the market over the long term, and ETFs are very cheap.
• Be diversified. I have tried to mix different types of assets, such as equities, bonds and alternative assets. And within the equity segment I have exposure to companies of different sizes listed in different geographic regions.
• Achieve good capital growth over time.

“I also intend to rebalance the portfolio from time to time if certain holdings get out of line. I think I have too much allocated to the UK, but that is because of historic investments. However, I have been reading about momentum investing which seems to be directly opposed to rebalancing. With one you keep the winners and sell the losers, and with the other you do the opposite. So which should I do?”

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

THE BIG PICTURE

Chis Dillow, Investors Chronicle's economist, says:

You ask whether to rebalance your portfolio or run with momentum. The trick here is to benefit from momentum effects without holding overpriced assets. It is, of course, impossible to do this perfectly. But a helpful rule is to hold assets when their prices are above their 10-month or 200-day moving average, and sell when they are below. This allows us to ride momentum but get out before it turns against us.

Doing this means you’ll not sell at the top but also that you don’t benefit from buying on dips. However, it will save you from the sort of savage bear market in which prices can fall by half or more. It is especially important to observe this rule for bubble-prone assets such as your robotics, IT and emerging markets ETFs.

You also ask whether there are risks in ETFs. There are – and on top of the risk of their assets falling in value. Unpopular ETFs sometimes close down. If this happens, you will get your money back, but perhaps at depressed prices. Another is tracking error, as ETFs don’t necessarily track the indices or assets they are supposed to replicate very well, in particular esoteric assets.

Then there is liquidity risk: with smaller ETFs bid-offer spreads can sometimes be large. This is a particular problem if you trade frequently – although you shouldn’t do this – or if you need to raise money in a hurry.

I’m not sure, though, that these risks should deter you. They certainly shouldn’t for the larger and more liquid ETFs that track the main indices and are a good basis for a portfolio.

James Norrington, specialist writer at Investors Chronicle, says:

You have no mortgage to worry about and your secure pension income is ample. This means you have plenty of capacity to take risk, so it really is a question of appetite. You have substantial expenses on the horizon – two possible weddings and a deposit for a flat – but you could start to put money towards those in a tax-efficient way now.

You and your wife each have a £3,000 annual gift allowance that is exempt from inheritance tax (IHT), so you could give your daughters £3,000 a year each to save towards their weddings and the flat deposit themselves. This wouldn’t reduce your or your wife’s nil-rate IHT bands. And if you could afford to make gifts out of regular income, proving to HM Revenue & Customs that you aren’t sacrificing your expected standard of living, these gifts won’t incur IHT anyway. If your daughters do eventually get married you can also make one-off gifts of up to £5,000 each free of IHT.

Paying money to your daughters now might also help you work out how much money you need to separate off for their life goals and how much you may need for your care when you are older. With the proviso that you’re not a money tree they can keep harvesting, it might make sense to let your daughters make the decisions on whether to keep the money you give them in cash or invest it. If they use their Lifetime Isa allowances they can get up to £1,000 a year from the government towards a first home, so these are worth considering. Use your money to help them maximise the money the government is offering.

Try to manage your personal finances in such a way that you are never in a position of having to sell out of investments to meet immediate obligations. The key to success is being able to have time in the markets and reinvest your gains. Over time the level of returns you make will be down to a variety of factors. These are market direction – the dominant factor in recent years – the premium for value being realised, the premium for the risks of investing in smaller companies and the momentum premium you have identified.

You shouldn’t bet against momentum, but there are periods when momentum strategies have done very badly, even though, overall, momentum has outperformed. Rebalancing your portfolio is not the same as exiting winning trades completely. You maintain a position in markets with momentum, but you aren’t overexposed if the factor goes off the boil.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You ask what should be the balance between cash and investments. For you, more than other investors, there’s a case for having lots of cash, because you have significant expenses in the next two years. These mean you should not be fully invested in equities because there’s a danger you might need to sell shares at the wrong time – when prices are low – to meet these expenses. Investment decisions such as when to buy or sell should be taken for investment reasons, not because of personal circumstances.

That said, there are also two reasons not to hold very much cash.

One is that you will not get a 5 per cent a year return on average without a big equity holding. Real returns on cash are unlikely to be significantly positive for at least another couple of years. If you’re holding a lot of cash, you must expect low real returns on your portfolio as a whole.

And you have holdings in bonds and gold. These help to spread equity risk, which means you can take on more equities. You don’t need so much cash.

Ultimately, though, the question about the balance between risk and return is a personal one. The key thing is to have a balance you are comfortable with. If you worry about not growing your wealth fast enough, you have too much cash. If you worry about losing money, you have too little. The split between cash and equities is the fundamental question you should ask about asset allocation. Everything else is second order.

James Norrington says:

You are aware of the importance of diversification, but as you start to invest more capital the weightings in different asset classes will need to be considered carefully. Having over half your wealth in cash seems an excessively defensive position in your circumstances, as cash is just going to be eroded by inflation.

You also want to spend money on travel and other expenses in your retirement. The pound has recovered some ground since the Brexit vote but, compared with two years ago, sterling is still weak against the euro and the US dollar. Having more invested gives you a chance of growth to compensate for the declining purchasing power of your money.

The problem you face is that asset prices are dear and some of the assets that were traditionally risk-free, such as government bonds, now look like return-free risks as rising interest rates will cause capital losses for bond funds. So the best bet for inflation-beating returns looks like global equities.

Also, if you think about your wealth holistically, you already have considerable diversification and can take on more equity risk in the investment portfolio. You own your own home, which gives you UK residential property exposure, and have a guaranteed pension that gives you a fixed income. So it’s reasonable to have a higher proportion of the portfolio in equity markets.

This raises the question of how to manage the risks of investing more in an asset class that is more volatile. As you aren’t a professional money manager tasked with beating a benchmark you can maintain more of a cash reserve. You’re losing money through inflation, but think of it as the cost of insurance against an equity market crash. In our recent tactical asset allocation portfolios we increased cash to 12.5 per cent. We’ll underperform fully invested portfolios if equities start 2018 strongly but we’ll still do well in absolute terms. If markets do badly then we have some degree of protection.

You like ETFs for cheap and easy access to a variety of investment themes and geographies. These funds are an excellent addition to an investor’s armoury, but I would also use some managed funds.

Many passive funds automatically allocate capital proportionately to the largest stocks by market capitalisation. This has worked over the past eight or nine years, as the main driver of stock returns has been market impetus, thanks to loose monetary policy. A global index such as MSCI World is quite skewed towards companies, especially in the US, that have benefited largely from flows of cheap money. But you may not be able to rely on passive gains continuing.

There is, however, potential support for some of the bigger US companies trading on high multiples. Several tech giants beat analysts’ earnings estimates in the last reporting season, and with a US tax cut on the horizon their share prices could benefit further. This is a good reason not to avoid the US market even though it looks expensive. But maybe your proportion of US exposure should be less than the proportion of global indices this country accounts for.

In other markets, such as the UK, there is not clear evidence to show that fund managers consistently underperform benchmarks. There have been stages of cycles when growth or value investments do better, and although the quantitative easing effect has been supportive of quality growth stocks, as the tide of easy money subsides it may be best to place your trust in experts to pick the best companies.