Risk and return are related

For an investor to have a higher expected return than the present, the investor must accept more risk in their investment portfolio. The converse is also correct; that by reducing risk in the portfolio so too is the expected return reduced.

It should also be noted that risk and return are related, not correlated. Just because an investor accepts an increased level of risk in their portfolio, they will not always be rewarded with higher returns.

Risk is also not just about volatility in the price of assets. It also encompasses the risk that you do not meet your longer-term goals by having too conservative a strategy in place, or that your assets do not maintain their purchasing power as the cost of living rises.

Diversification is a risk reduction tool

Assets are rarely perfectly correlated, so the inclusion of additional assets into a portfolio can reduce the risk of that portfolio. Investors can moderate some of the risks in their investment portfolio through diversification.

There is also a limit to the impact that diversification can have on reducing risk in an investment portfolio. An investment portfolio with too many assets can limit investment returns without a corresponding reduction in risk. A balance is therefore required between adequate diversification and maintaining an appropriate concentration of assets.

Asset allocation is the primary driver of risk and returns in an investment portfolio

How assets are allocated across investment sectors has a greater impact on investment outcomes than which assets in each investment sector are incorporated into the portfolio.

The allocation of assets to different investment sectors is driven by the objectives of the investor. For someone requiring access to their money in the short term (one to two years), capital secure assets such as bank deposits make sense. Conversely, someone wanting to grow their wealth over a longer time frame (at least five years plus) should be considering including assets such as shares and property into their investments.

Another consideration for investors is the income they wish to generate from their investments. Allocating assets to a portfolio incorrectly could see that portfolio produces insufficient income to meet the investor’s goals.

Matching goals to an appropriate spread of asset classes is one of the most important investment decisions for an investor to make.

Rebalancing assets is important

While setting an asset allocation is important, the benefits are somewhat diminished if the investment portfolio is not regularly rebalanced back to the target asset allocation.

The price of assets will move up or down over time. This will result in the investment portfolio moving away from the original target asset allocation. Left this way, the investor may be over or under-exposed to certain asset classes which could subsequently see them miss out on achieving their objectives.

Regularly rebalancing a portfolio of assets back to the original target asset allocation ensures the investments remain on track to achieve the investors identified goals.

Rebalancing means that when asset prices move up, an investor will sell part of those assets to keep their allocation in line. When asset prices move down, an investor will buy more of those assets to again keep their allocation in line. Over time this will lead to an investor “selling high and buying low”, a recipe for enhancing investment returns over the longer term.

Is your investment portfolio asset allocation matched to your longer-term goals?  If you are unsure, then perhaps a discovery call with one of our highly skilled Private Client Advisers would be beneficial to explore your investment strategy in more detail. If you’d like to book a discovery call, please click HERE.