Balancing risk and return in your investment portfolio
Effective portfolio management is crucial in achieving financial success and building long-term wealth. It involves strategically allocating your investments across various asset classes such as equities, bonds, real estate (property), and commodities, and to achieve a balance between managing risk and generating sufficient return.
Understanding risk and return
Risk refers to the uncertainty of achieving desired investment outcomes. Different types of risks, including market risk, credit risk, liquidity risk, and inflation risk, can impact investment performance. Your risk tolerance determines your willingness and ability to take on investment risks. Factors such as financial goals, your investment horizon, and personal circumstances influence your risk tolerance.
Return is the reward or gain received from an investment. It has two components namely capital appreciation (the increase in the value of the investment) and income (dividends, interest, rental income, etc.).
Investors can generally expect higher returns for taking on more risk. Understanding that there is a risk-return trade-off can help in setting realistic investment objectives.
Building a diversified portfolio
Diversification is a risk management strategy that involves spreading investments across different asset classes, industries, and regions. It helps reduce the impact of individual investment losses (lower risk) and enhances the potential for consistent returns. Diversification is most effective when the different investment instruments in your portfolio do not typically move in the same way.
Asset classes
To be well diversified, investors should aim to have exposure to different asset classes. Your risk tolerance will determine the proportion of each asset class in your portfolio.
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Equities provide the most potential for long-term capital appreciation but comes with higher volatility and market risk. Investors with higher risk tolerance with a longer-term investment horizon will typically have a greater proportion of their assets invested in equities.
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Bonds: Fixed-income securities offer income generation and a higher likelihood of capital preservation but have lower potential for capital growth. Investors with lower risk tolerance and shorter investment horizons will typically have a greater allocation to bonds in their portfolio.
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Real Estate: Property provides income, potential appreciation, and diversification benefits.
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Commodities: Including commodities like gold, oil, or agricultural products can act as a hedge against inflation and aid in diversification as they usually have a low correlation to other investment instruments.
Other risk-reduction techniques
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Dollar-cost averaging: Investing a fixed amount at regular intervals rather than a large lump sum reduces the impact of short-term market fluctuations and helps investors maintain disciplined accumulation during market downturns.
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Stop-loss orders: Placing stop-loss orders allows investors to limit potential losses by selling a security when it reaches a predetermined price.
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Hedging strategies: Options, futures, contract for differences (CFDs) and other derivatives can be used to hedge against downside risks.
Monitoring and rebalancing
Monitoring your portfolio helps you identify underperforming assets and make informed decisions based on changing market conditions. Key performance metrics like total return, risk-adjusted return, and portfolio volatility, can provide insight into your portfolio performance.
Rebalancing involves adjusting the portfolio's asset allocation periodically to maintain the desired risk-return characteristics. This is necessary because changes in asset prices and market conditions can lead to deviations from your desired asset allocation.
Advantages of portfolio management
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Enhanced returns: Effective portfolio management aims to optimise returns by strategically allocating your investments. Through careful asset selection, risk assessment, and balancing, portfolio managers can potentially achieve higher returns compared to investing in a single asset or security. By capitalising on opportunities in different asset classes, investors can take advantage of various market conditions and potentially enhance their overall returns.
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Customisation and flexibility: Portfolio management offers investors the flexibility to tailor their investment portfolios to their specific needs and objectives. Depending on individual risk tolerance, investment goals, and time horizons, portfolios can be constructed to align with these factors. Investors can choose from a wide range of asset classes, investment strategies, and risk management techniques to create a customised portfolio that suits their preferences.
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Professional expertise: Portfolio management allows investors to leverage the expertise of professional portfolio managers. These experts have in-depth knowledge of financial markets, investment analysis, and risk management techniques. They can provide valuable insights, conduct thorough research, and execute investment strategies on behalf of investors. This can be particularly beneficial for individuals who may not have the time, resources, or expertise to manage their investments effectively.
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Discipline and long-term approach: Portfolio management promotes a disciplined and long-term approach to investing. Rather than reacting to short-term market fluctuations, portfolio managers focus on the overall investment strategy and objectives. They consider factors such as asset allocation, rebalancing, and risk management on an ongoing basis. This disciplined approach helps investors stay focused on their long-term financial goals and reduces the likelihood of making emotional and impulsive investment decisions.
Disadvantages of portfolio management
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Over-diversification: While diversification is a key advantage of portfolio management, there is a risk of over-diversification. Over-diversification occurs when a portfolio becomes so diversified that potential gains from well-performing investments are diluted. It can also increase the complexity of managing the portfolio and make it challenging to monitor and rebalance effectively.
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Costs and fees: Professional portfolio management services typically come with associated costs and fees. These fees can include management fees, performance-based fees, and transaction costs. For investors with smaller portfolios or those seeking to minimise expenses, these costs can eat into overall investment returns.
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Loss of control: Entrusting the management of one's portfolio to a professional means relinquishing some degree of control over your investment decisions. Investors who opt for professional portfolio management services rely on the expertise and decision-making abilities of the portfolio manager.
