This post is part of a series on investment theory and philosophy.

Inflation and investment management

Inflation has an underestimated impact on investment returns over time.  Often people focus on the actual rates of return without reflecting on the impact of the increase in the cost of living.

The above chart shows how returns can be adversely affected by inflation.  While inflation is currently lower than historical averages, cash savings are currently losing money in real terms.

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This post is part of a series on investment theory and philosophy.

Market turbulence

In turbulent stock market periods it can be tempting to reduce the risk of your investment portfolio by biasing the portfolio more towards safer assets. However, in doing this, all that is really being achieved is to hamper future performance in the longer term, or even to lock in losses.  The best thing to do is to trust in the process of the portfolio and markets, so that you can benefit from any recovery in the market. A big stock market fall in one period is usually followed by a big gain afterwards.  These periods of turbulence are less important over time.

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This post is part of a series on investment theory and philosophy.

Market timing and investments

It can be tempting to try and make short term gains on investment portfolios by moving in and out of the different markets.  Even with very strong market and economic data, this is almost impossible to get right every time.   For this reason, portfolios should be put together on the basis of delivering longer term performance rather than taking active short term bets.   We try not to guess the market, as even fund managers get this wrong, with far more detailed data than we possess.  Instead, we focus on delivering stable returns over the medium to long-term using the principles outlined above.

The above chart shows the effect of missing the best month of returns going back to 1970.  Missing the best month drastically reduced returns, and in 3 year actually turned a positive year into a negative return.

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This post is part of a series on investment theory and philosophy.

Asset allocation

Portfolio construction generally starts with asset allocation.  This is the choice of which assets to use, and in what proportion.  This will be put together with a medium to long term view, and have a combination of assets that will work together to deliver the risks and returns you want.  Various academic research papers have analysed investment portfolios and have concluded that the majority of a portfolio’s performance over time can be attributed to this part of the process.

We take your risk profile and use this to determine your ideal investment mix using portfolios designed by Ibbotsen Associates,  Ibbotsen Associates are worldwide leaders in portfolio theory, and have designed portfolios to match the risks you expect to take with your money.  We then use our investment research process (below) to allocate a suitable mix of investment funds to match your individual needs.

Rebalancing your investment portfolio

Naturally, each of the assets contained in your investment portfolio will perform in a different manner. As such, over time, better performing assets will form a larger proportion of your portfolio, and therefore alter the risk of your portfolio.  To minimise the risks of this happening, at future reviews we will make recommendations to switch funds back towards the ideal asset allocation.

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This post is part of a series on investment theory and philosophy.

Diversification

The best way to manage risks with investments is to diversify your portfolio.  This can be in a number of ways such as increasing the number of holdings.  For example, if you hold 1 company in your portfolio and this fails, then you lose 100% of your investment.  If you hold 50 companies equally, and 1 fails, you only lose 2%.

This concept can extend to different types of asset (split between cash, fixed interest, shares and property), different geographical locations, and currencies.  In theory, the wider you diversify the smoother your returns.  Research has shown that this approach limits the downside of your portfolio without too much impact on the upside.

It is impossible to pick which asset class will be the best or worst performing in any given year, as this chart shows. Diversification of your investment portfolio will give you the best chance of minimising risks while smoothing out gains.

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