Before you invest, it’s important to know how much risk you are prepared to tolerate.
After all, there is no such thing as a risk-free investment. There are just gradations of risk and gradations of return probability. If someone approaches you with a proposal for a “high-return, low-risk/risk-free” investment opportunity, then it is almost certainly a scam.
So, what should you invest your money in? Most financial advisers will tell you that it depends on factors such as your personal goals, circumstances and income needs in the future.
Moreover, most advisers will also tell you to avoid putting all of your eggs in one basket – rather, spread out your investments across different assets.
This is called “asset allocation”, and it might involve putting your money into a range of investments such as stocks & shares, bonds, real estate and commodities (to name a few). However, what are the specific benefits of spreading your money out like this?
Minimise exposure to economic shocks
If you put all of your money into the stock market, what will happen if it falls? Most likely, your investment portfolio will take a big hit – at least in the short term.
Of course, markets typically correct themselves eventually and surpass where they were before. Yet by placing some of your investments in other assets such as government bonds (which are likely to weather a stock market storm), you can minimise the short-term damage to your investments – even if not eliminating it entirely.
Protect against political risks
In 2019-20 (at the time of writing) lots of UK landlords will know all too well about the impact government policy can have on an investment portfolio.
Up until 2016-17, landlords were allowed to deduct costs such as mortgage interest on Buy To Let properties from their rental income, for tax purposes. However, as of April 2017 this benefit has been gradually phased out – leading, in some cases, to much larger tax bills which are eating heavily into these leadlords’ profits.
By investing solely in one asset type, you leave yourself vulnerable to changes in government policy which could harm your investments later.
For landlords who have focused on developing a large real estate portfolio, this is especially painful due to the fact that property is highly illiquid (it’s difficult to move the money tied up in the properties into other, perhaps more profitable investments). However, other asset classes are vulnerable too.
By spreading your money across different assets types, you minimise your exposure to these kinds of political changes.
This might sound like another word for government policy – and to some degree there is overlap. However, here we’re not just talking about how a single change in the law can impact your investments. Rather, we’re looking at the whole financial system.
Cast your mind back to 2008 when the global financial crisis occurred. The widespread public anger over taxpayers’ money being used to “bail out” the banks was a big driving force behind the UK government’s decision to introduce huge changes to the financial system.
One of the results of this was the introduction of the Financial Conduct Authority (FCA), which was designed to protect consumers from unscrupulous financial firms and set a compliance framework in place or financial services companies to adhere to.
The Financial Services Compensation Scheme (FSCS) was also brought in to protect up to £85,000 within individuals bank accounts, in case their bank failed.
Moreover, the FCA was tasked with vetting and interviewing individuals who are presented as candidates to top-executive positions at important financial services companies.
Essentially, all of this points to a huge overhaul of the financial system which sought to stamp down on a lot of dangerous investment activity – particularly within the property market. It is not implausible that another financial crisis might happen in the not-too-distant future, and that this could lead to a further tightening of accountability, increased restrictions on how money can be invested, and greater transparency in the financial and other sectors.
Spreading out your investments into different asset types obviously cannot make your portfolio immune to any large-scale overhauls of the wider financial system. But it can minimise the turbulence you might experience, and give you other investment levers to pull on if doors start to shut which you could previously open (e.g. mortgage applications are generally now much harder to conclude than they were prior to 2008).
It’s important to note that changes to the regulatory framework can also create new investment opportunities and assets for you to tap into. For instance, the emergence of peer-to-peer lending in the UK (P2P) has often been credited to the increased reluctance of high street banks to lend to small businesses and startups – leading to the creation of new finance industries.
Asset allocation is the practice of spreading your money across different types of investments such as stocks, bonds, real estate, cash and commodities – in line with your personal goals, risk tolerance and available capital.
The benefits of doing so are largely tied up with risk mitigation. By putting your eggs in multiple baskets, you minimise your exposure to loss if one or more of them were to come into trouble. If the property or stock market dips, for instance, your cash and bond investments can help carry your investment portfolio through the turbulence.
Investment risk comes not just in the form of economic dips and “shocks” – but also in the form of government policy changes and overhauls of the wider financial regulatory framework. Again, by spreading your investments across different asset classes, you can reduce the impact that these changes can have on your portfolio – and possibly even give yourself a better chance of identifying and exploiting new investment opportunities which have emerged as a result.