Effective tool for reducing risk and volatility without necessarily giving up returns

When you start investing, or even if you are a sophisticated investor, one of the most important tools available is diversification. Whether the market is bullish or bearish, maintaining a diversified portfolio is essential to any long-term investment strategy.

Diversification allows an investor to spread risk between different kinds of investments (called ‘asset classes’) to potentially improve investment returns. This helps reduce the risk of the overall investments (referred to as a ‘portfolio’) underperforming or losing money.

With some careful investment planning and an understanding of how various asset classes work together, a properly diversified portfolio provides investors with an effective tool for reducing risk and volatility without necessarily giving up returns.

Investment decision process
Understanding investment risk and determining what level of risk you feel comfortable with before you invest is an important part of the investment decision process. Your potential returns available from different kinds of investment, and the risks involved, change over time as a result of economic, political and regulatory developments, as well as a host of other factors.

Your overall asset allocation needs to reflect: your future capital or income needs; the timescales before those capital sums are required or the
level of income sought; and the amount of risk you can tolerate.

Investing is all about risk and return. Not only does asset allocation naturally spread risk, but it can also help you to boost your returns while maintaining, or even lowering, the level of risk of your portfolio. Most rational investors would prefer to maximise their returns, but every investor has their own individual attitude towards risk.

Investment characteristics
Determining what portion of your portfolio should be invested into each asset class is called ‘asset allocation’ and is the process of dividing your investment(s) between different assets. Portfolios can incorporate a wide range of different assets, all of which have their own characteristics, like cash, bonds, equities (shares in companies) and property.

The idea behind allocating your money between different assets is to spread risk through diversification and to understand these characteristics, and their implications on how a portfolio will perform in different conditions – the idea of not putting all your eggs in one basket.

Looking into the future
Investments can go down as well as up, and these ups and downs can depend on the assets you’re invested in and how the markets are performing. It’s a natural part of investing. If we could look into the future, there would be no need to diversify our investments. We could merely choose a date when we needed our money back, then select the investment that would provide the highest return to that date.

Moreover, the potential returns available from different kinds of investment, and the risks involved, change over time as a result of economic, political and regulatory developments, as well as a host of other factors. Diversification helps to address this uncertainty by combining a number of different investments.

Asset classes
When putting together a portfolio, there are a number of asset classes, or types of investments, that can be combined in different ways. The starting point is cash – and the aim of employing the other asset classes is to achieve a better return than could be achieved by leaving all of the investment on deposit.

Cash
The most common types of cash investments are bank and building society savings accounts and money market funds (investment vehicles which invest in securities, such as short-term bonds, to enable institutions and larger personal investors to invest cash for the short term).

Money held in the bank is arguably more secure than any of the other asset classes, but it is also likely to provide the poorest return over the long term. Indeed, with inflation currently above the level of interest provided by many accounts, the real value of cash held on deposit is falling.

Your money could be eroded by the effects of inflation and tax. For example, if your account pays 5% but inflation is running at 2%, you are only making 3% in real terms. If your savings are taxed, that return will be reduced even further.

Fixed Interest Securities
Fixed Interest Securities (also called ’bonds’) are effectively IOUs issued by governments or companies. In return for your initial investment, the issuer pays a pre-agreed regular return (the ‘coupon’) for a fixed term, at the end of which it agrees to return your initial investment. Depending on the financial strength of the issuer, bonds can be very low or relatively high risk, and the level of interest paid varies accordingly, with higher-risk issuers needing to offer more attractive coupons to attract investment.

As long as the issuer is still solvent at the time the bond matures, investors get back the initial value of the bond. However, during the life of the bond, its price will fluctuate to take account of a number of factors, including:

Interest rates – as cash is an alternative lower- risk investment, the value of government bonds is particularly affected by changes in interest rates. Rising base rates will tend to lead to lower government bond prices, and vice versa.
Inflation expectations – the coupons paid by the majority of bonds do not change over time. Therefore, high inflation reduces the real value of future coupon payments, making bonds less attractive and driving their prices lower.
Credit quality – the ability of the issuer to pay regular coupons and redeem the bonds at maturity is a key consideration for bond investors. Higher-risk bonds such as corporate bonds are susceptible to changes in the perceived credit worthiness of the issuer.

Shares
Shares, or equities in companies, are regarded as riskier investments than bonds, but they also tend to produce superior returns over the long term. They are riskier because, in the event of a company getting into financial difficulty, bond holders rank ahead of equity holders when the remaining cash is distributed.

However, their superior long-term returns come from the fact that, unlike a bond (which matures at the same price at which it was issued), share prices can rise dramatically as a company grows.

Returns from shares are made up of changes in the share price and, in some cases, dividends paid by the company to its investors. Share prices fluctuate constantly as a result of factors such as:

Company profits – by buying shares, you are effectively investing in the future profitability of a company, so the operating outlook for the business is of paramount importance. Higher profits are likely to lead to a higher share price and/or increased dividends, whereas sustained losses could place the dividend or even the long-term viability of the business in jeopardy
Economic background – companies perform best in an environment of healthy economic
growth, modest inflation and low interest rates. A poor outlook for growth could suggest waning demand for the company’s products or services. High inflation could impact companies in the form of increased input prices, although in some cases companies may be able to pass this on to consumers. Rising interest rates could put strain on companies that have borrowed heavily to grow the business
Investor sentiment – as higher-risk assets, equities are susceptible to changes in investor sentiment. Deterioration in risk appetite normally sees share prices fall, while a turn to positive sentiment can see equity markets rise sharply

Property
In investment terms, property normally means commercial real estate – offices, warehouses, retail units and the like. Unlike the assets we have mentioned so far, properties are unique – only one fund can own a particular office building or shop.

The performance of these assets can sometimes be dominated by changes in capital values. These unusually dramatic moves in capital value illustrate another of property’s key characteristics, namely its relative illiquidity compared to equities or bonds. Buying equities or bonds is normally a relatively quick and inexpensive process, but property investing involves considerable valuation and legal involvement.

The more normal state of affairs is for rental income to be the main driver of commercial property returns. Owners of property can enhance the income potential and capital value of their assets by undertaking refurbishment work or other improvements. Indeed, without such work, property can quickly become uncompetitive and run down. When managed properly, the relatively stable nature of property’s income return is key to its appeal for investors.

Diversification
Diversification helps to address uncertainty by combining a number of different investments. In order to maximise the performance potential of a diversified portfolio, managers actively change the mix of assets they hold to reflect the prevailing market conditions. These changes can be made at a number of levels, including the overall asset mix, the target markets within each asset class, and the risk profile of underlying funds within markets.

As a rule, an environment of positive or recovering economic growth and healthy risk appetite would be likely to prompt an increased weighting in equities and a lower exposure to bonds. Within these baskets of assets, the manager might also move into more aggressive portfolios when markets are doing well, and more cautious ones when conditions are more difficult. Geographical factors such as local economic growth, interest rates and the political background will also affect the weighting between markets within equities and bonds.

In the underlying portfolios, managers will normally adopt a more defensive positioning when risk appetite is low. For example, in equities, they might have higher weightings in large companies operating in parts of the market that are less reliant on robust economic growth. Conversely, when risk appetite is abundant, underlying portfolios will tend to raise their exposure to more economically sensitive parts of the market and to smaller companies.

Least financially resilient group delay life milestones due to financial insecurity

Life can get complicated when you hit your early thirties, which means your finances are starting to get serious. You might be in the middle of countless transitions, like moving up in your career, starting a business, buying a home, getting married, having children…and a whole lot more.

A study[1] reveals that people in their early thirties are putting off life milestones, such as having children or buying a home, due to being one of the least financially resilient groups in the UK. A quarter (24%)[1] of the 30 to 35-year-olds in the study, of which there are 4.7 million in the UK, feel worried about the financial impact of life milestones – double the national average (12%)[1]. Nearly one in six (17%)[1] say they’ve put off major life milestones because they don’t feel financially mature enough.

30 years or more from retirement 
The great advantage of being in your thirties is your age – you may still be some 30 years or more from retirement and have plenty of time to right the excesses of your twenties. The potential downside, however, is that if you don’t act now, these mistakes could colour your future financial health. Worryingly, seven out of ten under-35s believe their youthfulness will last forever[3], so they don’t properly prepare for risks the future may hold.

The study also found that more than seven in ten (73%)[1] of this age group fall short of the Money Advice Service (MAS)[2] recommended amount of savings to be financially resilient, versus a national average of 56%[1].

Unable to work due to illness or an accident
The research revealed a further one in five (22%)[1] in their early thirties don’t know how long they would be able to cope financially if they found themselves unable to work – for instance, due to illness or an accident. Despite this, fewer than one in twelve working adults (7%)[1]
have their own Income Protection insurance in place.

These findings – that many of those in their early thirties are delaying major life milestones because they feel worried, unconfident and ill-prepared financially – are very concerning. And it is worrying that so few can withstand the financial effects of an unexpected income shock – they have no Plan A, nor a Plan B.

Little provision to handle a financial crisis
With low financial confidence and little provision to handle a financial crisis, there is a clear need for a safety net – a form of ‘independence plan’. There are multiple reasons this age group isn’t properly preparing for financial risks. A universal emphasis on the importance of ‘staying young’ means many people are in a state of denial or avoidance when it comes to facing up to the future. We also tend to talk within – rather than across – generational groups, which encourages us to focus inwardly on the present, not the future.

Previously, younger generations would likely inherit their parents’ estate while relatively young, but increased life expectancy means this is no longer the case. By not giving proper weight to their financial status, this group could be at risk of finding themselves with a significant level of responsibility without adequate financial preparation or protection.

Source data:
[1] Methodology for consumer survey: YouGov, on behalf of LV=, conducted online interviews with 8,529 UK adults between 20–26 June 2018. Data has been weighted to reflect a nationally representative audience.
[2] Methodology for recognised benchmark of financial resilience: Money Advice Service (MAS) guidelines for financial resilience state that ‘people should hold an emergency fund of three months’ income’. LV= identified the ‘least financially resilient’ groups based on the combined factors of how respondents fared against the MAS definition and how confident respondents reported to feel about being able to manage a financial crisis.
People in their early thirties were identified as one of the least financially resilient groups using the following methodology: 30 to 35-year-olds were identified as the least financially resilient age group, with 73% falling short of having 90 days’ worth of outgoings in the bank against the national average of 33%. Within this age group, 43% lack confidence in handling a financial crisis, versus the national average of 34%.
[3] Dr David Lewis, ‘Life Unlimited – Peak Performance Past Forty’, to be published late 2018

Getting away from the stresses of everyday life

For many, the idea of retirement means getting away from the stresses of everyday life. But with living costs rising and interest rates low, people need to think about how to generate extra income from their savings in retirement.

Pensions offer a number of important advantages that will make your savings grow more rapidly than might otherwise be the case. However, changes announced in April 2015 have lead to a complete shake-up of the UK’s pensions system, giving people much more control over their pension savings than ever before.

Different pension schemes
The term ‘private pension’ covers both workplace pensions and personal pensions. The UK Government currently places no restrictions on the number of different pension schemes you can be a member of. Providing you don’t save more than your Lifetime Allowance into all of your pension funds combined – currently set at £1,030,000 (2018/19) – you won’t be penalised by the taxman for having lots of pensions.

So even if you already have a workplace pension, you can have a personal pension too, or even multiple personal pensions. These can be a useful alternative to workplace pensions if you’re self-employed or not earning, or simply another way to save for retirement.

Any UK resident between the ages of 18 and 75 can pay into a personal pension – although the earlier you invest, the more likely you are to be able to build up a substantial pension pot.

Tax relief on pension contributions
A private pension is designed to be a tax-efficient savings scheme. The Government encourages this kind of saving through tax relief on pension contributions.
In the 2018/19 tax year, pension-related tax relief is limited to either 100% of your UK earnings, or £3,600 per annum.

The current pension tax relief rates are:
Basic-rate taxpayers will receive 20% tax relief on pension contributions
Higher-rate taxpayers also receive 20% tax relief, but they can claim back up to an additional 20% through their tax return
Additional-rate taxpayers again pay 20% tax relief, but they can claim back up to a further 25% through their tax return
Non-taxpayers receive basic-rate tax relief, but the maximum payment they can make is £2,880, to which the Government adds £720 in tax relief, making a total gross contribution of £3,600

If you are a Scottish taxpayer, the tax relief you will be entitled to will be at the Scottish Rate of Income Tax, which may differ from the rest of the UK.
Limits on the amount that can be contributed

The Annual Allowance is a limit on the amount that can be contributed to your pension each year while still receiving tax relief. It’s based on your earnings for the year and is capped at £40,000 (2018/19).

If you exceed the Annual Allowance in a year, you won’t receive tax relief on any contributions you paid that exceed the limit, and you will be faced with an annual allowance charge. This charge will form part of your overall tax liability for that year, although there is the option to ask your pension scheme to pay the charge from your benefits if it is more than £2,000.

In April 2016, the Government introduced the tapered annual allowance for high earners, which states that for every £2 of income earned above £150,000 each year, £1 of annual allowance will be forfeited. However, the maximum reduction will be £30,000 – taking the highest earners’ annual allowance down to £10,000.

It is worth noting that you may be able to carry forward any unused annual allowances from the previous three tax years. If you have accessed any of your pensions, you can only pay a maximum of £4,000 into any un-accessed pension(s) you have. This is called the ‘Money Purchase Annual Allowance’, or ‘MPAA’. The MPAA applies only if you have accessed one of your pensions.

Exceeding the Lifetime Allowance
What counts towards your Lifetime Allowance depends on the type of pension you have.

Defined contribution – personal, stakeholder and most workplace schemes. The money in pension pots that goes towards paying you, however you decide to take the money.
Defined benefit (also known as ‘Final Salary’) – some workplace schemes. This can be 20 times the pension you get in the first year plus your lump sum – but you’ll need to check this with your pension provider.

Your pension provider will be able to help you determine how much of your Lifetime Allowance you have already used up. This is important because exceeding the Lifetime Allowance will result in a charge of 55% on any lump sum and 25% on any other pension income such as cash withdrawals.
This charge will usually be deducted by your pension provider when you access your pension.

Protecting your pension pot
It’s easier than you think to exceed the Lifetime Allowance, especially if you have been diligent about building up your pension pot. If you are concerned about exceeding your Lifetime Allowance or have already done so, it’s essential to obtain professional financial advice.

It may be that you can apply for pension protection. This could enable you to retain a larger Lifetime Allowance and keep paying into your pension – depending on which kind of protection you are eligible for:

Individual protection 2016 – this protects your Lifetime Allowance to the lower of the value of your pension(s) at 5 April 2016 and/or £1.25 million. You can keep building up your pension with this type of protection, but you must pay tax on money taken from your pension(s) that exceeds your protected lifetime allowance.

Fixed protection 2016 – this fixes your Lifetime Allowance at £1.25million. You can only apply for this if you haven’t made any pension contributions after 5 April.

Passing on your pension to beneficiaries
Finally, it is worth noting that there will normally be no tax to pay on pension assets passed on to your beneficiaries if you die before the age of 75 and before you take anything from your pension pot – as long as the total assets are less than the Lifetime Allowance. If you die aged 75 or older, the beneficiary will typically be taxed at their marginal rate.
However, not all types of pension can be passed on in such a tax-efficient way. Some older-style pensions may not be able to offer all the new death benefit options available. If this flexibility is important to you, in this instance and if appropriate, you may want to consider transferring to a pension scheme that does.

A PENSION IS A LONG-TERM INVESTMENT.

THE FUND VALUE MAY FLUCTUATE AND CAN GO DOWN, WHICH WOULD HAVE AN IMPACT ON THE LEVEL OF PENSION BENEFITS AVAILABLE.

PENSIONS ARE NOT NORMALLY ACCESSIBLE UNTIL AGE 55. YOUR PENSION INCOME COULD ALSO BE AFFECTED BY INTEREST RATES AT THE TIME YOU TAKE YOUR BENEFITS. THE TAX IMPLICATIONS OF PENSION WITHDRAWALS WILL BE BASED ON YOUR INDIVIDUAL CIRCUMSTANCES, TAX LEGISLATION AND REGULATION, WHICH ARE SUBJECT TO CHANGE IN THE FUTURE.

THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.

PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.

Visualising what really matters to you is the key to the planning process

Have you ever thought about writing a letter to yourself to describe your ideal future life, long-term life goals and the process of how to plan for them? Imagining what you want your life to be like in the long term when you retire can help you think much further ahead than you might ever have done before. Research conducted for a new campaign[1] shows that over half (54%) of people plan their lives only days (31%) or weeks (23%) ahead.

The participants were asked to look deep into their future lives in a bid to uncover what really matters to them. When asked to write a letter to describe their ideal future lives, people were very good at imagining it. But many didn’t know how they were going to achieve it or how to take the next step to build a bridge from now to that future self by putting a plan in place to get there.

Key well-being aspirations
The writing exercise uncovered how people really envisage their life in the future. The letters illustrate that well-being in old age pivots on simple hopes (family, health and happiness) rather than extravagant financial ambitions. A well-balanced life was a key aspiration for many respondents. The letters confirm a clear hierarchy of needs and aspirations in life that many of us would have expected: family/partner, followed by career and financial security, followed by hobbies and interests, including friends.
While a handful of the respondents hope for lottery wins or gold medal glory, the overwhelming majority express their desire to remain healthy and active in old age and to live ‘comfortably’ with some degree of financial security. The letters revealed a nation aspiring to much more grounded ambitions: the centrality of family, a desire to travel to learn throughout life and to have fulfilling but balanced careers with a good work/life balance.

Family, health and happiness
It’s not surprising that family, health and happiness are central pillars of people’s well-being. What is surprising is how unprepared most people are to achieve the dreams they have described. The letters are wonderfully optimistic, but there is a reality check. The findings showed that people underestimate their required size of pension pots by up to £550,000, while many people who have the capacity to save aren’t doing so.

By using the letter as a catalyst, once you know what your goals are, the next step is to plan for them. To support the letter writing campaign, a study was also commissioned to gauge people’s current well-being and life goals[2]. The survey indicates a fundamental disconnect between the life people aspire to and their life now.

Prevention barriers in equal measure
The study found over half (54%) of people plan their lives only days (31%) or weeks (23%) ahead. While 14% of respondents said they plan for years ahead, very few (4%) plan for future decades. This may explain why only 11% of UK adults with life goals know how they will achieve them.

When it comes to life goals for the future, travel is a primary ambition for over two in five people (44%), followed by eating well (40%), getting fit (39%), more time with friends and family (36%) and better work/life balance (20%). Money is the main thing (33%) preventing people from achieving their goals, then motivation (28%), followed by energy and time as barriers in equal measure (26%).

Path to financial freedom
When it comes to financial goals, one in five people (20%) have none whatsoever. Among those with goals in mind, the same percentage of people (20%) have not worked out a strategy and don’t know how they will achieve their specific goals. The top financial goals are: save for a rainy day (43%); earn more money (32%); save for a special occasion (21%); reduce or clear debts (19%); and buy property and pay off mortgage (both 17%).

Your finances touch just about every aspect of your life. Your personal life and your financial life are not separate – they intertwine with each other. Your path to financial freedom means identifying and harnessing your dreams and bringing them alive. We can help you find an answer. Whatever stage of life you’re at, we can guide you through the opportunities and challenges you face.

Source data:
[1] The Brewin Dolphin letter writing project asked 500 UK adults to write a letter to their future selves deep into old age – a letter their ‘future self’ may discover and read as they reflect back on life. Methodology: online survey completed by 500 economically active respondents aged 18–65. Fieldwork by Trajectory from 12–20 April 2018.
[2] The survey polled over 2,000 UK adults about their life now, their well-being and attitude to money, plus what they want in the future – personal and financial goals, and how they’ll achieve them. Methodology: online survey was completed by 2,004 UK adults (18+). Fieldwork by Opinium from 11–14 May 2018.