This month, the FCA published a report on investment platforms that warned “the risks and expected returns of model portfolios with similar risk labels are unclear”.
With many consumers putting their trust in platforms to pick them a portfolio, knowing that your ‘conservative’ portfolio really is low-risk (for example) is hugely important.
The problem with defining risk is that it can be subjective.
This means that using a broad, descriptive term to describe a portfolio’s risk can be misleading and cause confusion. Portfolios with similar descriptive names can produce vastly different levels of volatility and performance.
Don’t just look at the label on the portfolio – here’s how you can better understand the risk you’re being exposed to.
This article is part of a wider series on investing, covering all areas from stocks and shares to buy-to-let, peer-to-peer and alternative investments. Click here to view the full guide.
Why asset allocation matters
Asset allocation tends to be a common approach when it comes to controlling portfolio risk, as a basic premise of investing is to hold a diversified of mix of assets.
Some portfolio managers will look at allocating certain amounts to equities, fixed interest, property and cash, depending on what a traditional ‘conservative, balanced and aggressive’ portfolio should look like.
However, there are other methods, such as looking at the historic volatility of asset classes and how they correlate to each other and formulating a movable asset allocation framework from the empirical data.
Conservative vs aggressive
There is no right or wrong way of defining portfolio risk, but there are certain factors that investors can analyse to understand the level of risk is suitable for them.
The starting point would be to see how much a portfolio can hold in equities.
A good indicator for this would be the three Investment Association (IA) sectors:
- Mixed Investment 0-35% Shares
- Mixed Investment 20-60% Shares
- Mixed Investment 40-85% Share
These sectors provide an indication as to how much a portfolio will allocate to equities.
A conservative portfolio, for example, should not exceed 35% in equity exposure and 60% for a balanced portfolio.
This rule does not have to be so stringent for an aggressive portfolio because investors, in this risk profile, should be able to tolerate 100% equity exposure at times.
However, for an aggressive portfolio, the equity allocation should not go below 60%.
The Investment Association has an easy-to-use glossary of investment terms on its website.
Where are you invested?
The next thing to consider is the mix of assets held within the portfolio.
A concentrated portfolio can mean higher levels of risk. If the equity component is focused purely on investing in UK smaller companies, this is a high-risk strategy.
However, if the equity exposure is diversified between different markets both at home and abroad, this should generate better risk-adjusted returns over the long-term.
The same concentration test can be applied to other asset classes.
Within a cautious portfolio there is likely to be a sizeable allocation to fixed interest, but if this is invested wholly in, say, UK gilts then this part of the portfolio lacks diversification and adds overall risk.
The mix of assets in your portfolio should also be reviewed on an ongoing basis because people’s circumstances and risk attitudes do change over time, especially as they get older and build up greater levels of wealth.
This is where professional independent advice can play an important role. Identifying investment risk is a key function of an adviser.
They will undertake a full fact-find and assess current assets and liabilities and agree, through dialogue, what the investor’s investment objectives are and how much risk they are willing and able to take.
The adviser should then recommend a suitable investment solution. This will be agreed and then reviewed on an ongoing basis, to ensure the portfolio continues to meet the investor’s investment objectives and risk profile over time.
Ben Willis is head of portfolio management at independent financial advisers Chase de Vere. The views expressed in this article do not necessarily represent those of loveMONEY.
The information included in this article does not constitute regulated financial advice. You should seek out independent, professional financial advice before making an investment decision.