Investment Planning

Investment planning is at the core of most financial planning, since it is the nature of the investments you own and the returns they generate that are often of the greatest importance in achieving your goals, especially for retirement income.

FiveWays’ investment approach is based on the fact that for most people, preserving capital is more important than gaining higher returns on their money. We therefore describe our approach as fundamentally conservative and try to design portfolios that limit potential losses in the next ‘once in a generation’ crash. In our experience, crises in fact occur more often than once in a generation, and if you are drawing on your capital for retirement income you need to avoid their potentially disastrous effects.

Chris Gilchrist chairs FiveWays’ investment committee. He has written five books on personal finance and investment and edits a monthly investment newsletter, The IRS Report.

“I got my first job in financial journalism when I left university in 1970, just in time to see the end of the 1969-70 bear market. That seemed pretty bad, but after a short-lived boom we then had the father and mother of all bear markets in 1973-74 in which the value of UK shares, after adjusting for inflation, fell by two-thirds – an even bigger slump than the Great Crash of 1929 on Wall Street. Not long after that we had another crisis, when the UK was virtually bankrupt in 1976 and Chancellor Denis Healey had to go cap-in-hand to the IMF for a loan to ‘bail Britain out’.

Under Margaret Thatcher, we had a great rise in the stock market, along with a wave of privatisations including British Telecom and British Gas, but before that bull market started there was a tough period from 1979-81, and another tough time after a housing boom collapsed in 1989. Then we had a couple of crises in the nineties, one of which saw mortgage rates rising to 17%. I saw most of these events from the ringside seat you get as a financial journalist, and learnt that the one repeated mistake everyone made – professionals as well as individual investors – was to underestimate the risk of another crisis. There always was another crisis – it was only a question of how long it took to come along.

So while investors have to take risk – if you don’t, you will never get inflation-beating returns on your money – you must also be realistic and try to limit the risks to your capital to what you can realistically afford. That is the focus of myself and my colleagues on FiveWays’ investment committee – doing what we can to limit and contain risk while getting reasonable returns on your money.”

Will your money run out before you do?

Chris Gilchrist

Risk and suitability assessment

We regard risk as having three dimensions: your need to take risk, your capacity to take risk and your tolerance of risk. We take all of them into account in deciding what level of risk we think you can afford and need to take to achieve your aims.

Need for risk

We start with your objectives: retirement, children’s education, purchase of holiday home, capital for own business, 30-foot yacht, and so on. These objectives, when they are translated into financial terms, tell us what specific sums of money are needed as income or capital at certain dates in the future. That then tells us what annual returns would be required on the capital you have and any additional savings you accumulate.

Often people’s objectives are unrealistic – they would require such a high rate of return to be achieved that they are virtually unattainable. It is a normal part of the planning process to negotiate changes in goals, timescales and resources – including savings towards goals – so that your objectives are achievable.

On the other hand, if you have substantial assets, you may be able to achieve your objectives with only very modest rates of return, in which case we must ask if you have any reason to take more risk than you need to (fear of future inflation might be one reason for doing this).

The link between what you have now and what you may have in the future is the long-term rates of return that have historically been earned on the major asset classes: cash, bonds, commercial property and equities. We have a lot of history for investment returns and think that taking the long-term average as the likely rate for future returns is a reasonable approach, with the proviso that in the future, as in the past, the actual rate of return you get over any period of up to 5 years can be much higher or lower than the long-term average. Since inflation has varied a lot, it is more practical to think in terms of the ‘real’ rate of return, namely the return in excess of the rate of inflation over the relevant period, which represents the real spending power of your money.

For a balanced portfolio, an average annual return of 3-4% in excess of inflation would be a realistic projection for a term of ten years or more. The long-term data from Barclays is shown in the table.

Long-term returns from UK investments

These are the annual returns to end-December 2015 adjusted for inflation but before tax. Source: Barclays Equity Gilt Study 2016

Capacity for risk

In our view capacity for risk – how much risk you can afford to take – is the most important dimension, because most people find it hard to work out for themselves. To assess this we ask what effect a permanent decline in income or capital, or a shortfall in future income or capital compared with your goals, would have on your standard of living. If your standard of living would be seriously compromised, you have a low capacity for risk and even if you could tolerate higher risk, we will caution you against it.

Some factors reduce an individual’s capacity for risk, for example: poor health, low pension income expectations, high debt liabilities, minimal resources other than invested capital, a need to withdraw money in the near future. Others increase capacity, such as: high index-linked pension entitlement, large resources other than investment, low liabilities, high capital expectations (such as an inheritance), a long investment timescale.

We take all relevant circumstances into account in making an assessment of your risk capacity. This will always carry more weight in our overall assessment than your tolerance of risk.

Tolerance of risk

Your tolerance of risk – how much risk you can take and still sleep at night – is affected by both your personality and your experience. As regards personality, there is evidence that your attitude to risk is a stable feature of your personality, but your tolerance of risk is much affected by your experience. For example, people who have never owned investments can be nervous about stock markets, while those who have owned investments for some time become used to the normal range of fluctuations. And if you have followed economics and markets, or have business experience, you are also likely to know and understand more about the uncertain nature of financial markets and are therefore likely to be more tolerant of risk. This is important because we believe people should not invest in ways that take them outside their ‘sleep at night’ comfort zone.

Harbour Suitability & Risk assessment

Our Harbour Suitability and Risk assessment system asks 20 questions covering all three dimensions of risk. The questions are scored to generate a provisional allocation to one of five Profiles, each of which corresponds to an expected range of returns, volatility and potential loss. Because Harbour can only capture a limited range of personal data, its provisional score and the Profile it generates can be overridden by the adviser based on their more detailed knowledge of your circumstances.

The Suitability Report we create for you through Harbour includes your responses to all questions as well as all adviser comments, so it gives you a full understanding of the reasons for our assessment. And it gives you an indication of the likely range of returns and volatility of the kind of investments we will recommend based on your Profile.

Investment solutions

Long-term performance of shares compared with inflation

An investment of £100 in shares in 1991 grew to £935 in 2015 assuming all the dividends were reinvested. The amount you needed to keep pace with inflation over that period was £205.

Our model divides capital between five asset classes: Cash, Fixed Interest, Commercial Property/Infrastructure, Equities and Alternative/Absolute Return. By allocating capital to Absolute Return strategies with strict downside risk controls, we can limit potential losses in a way that is not possible using only the traditional four asset classes. The more cautious your investment profile, the greater the proportion of your capital we allocate to defensive strategies of this kind.

The Profile generated by the Harbour assessment determines the risk-return characteristics of the investments we recommend. The percentage of capital invested in the riskiest asset class, equities, is low in Cautious and Conservative portfolios and higher in Balanced, Progressive and Adventurous. Risk is also managed within the asset classes: for example, there are riskier equity funds in the Adventurous than in the Cautious portfolio. On the other hand, Absolute Return, with limited risk of loss, accounts for a higher proportion of capital in our Cautious and Conservative than Adventurous portfolios.

In general, we recommend portfolios of investment funds that are managed on a discretionary basis. Using funds means that even with a small sum of capital you get a very wide spread of investments, which helps to reduce risk. Using a discretionary service means that timely changes can be made without requiring your prior approval and that the portfolio will remain within the boundaries, especially of maximum possible loss, that it started with.

We run our investment solutions on ‘platforms’, which are on-line administration engines that hold your investments, along with cash and income accounts. In all cases, the platform enables you to flexibly manage additions, withdrawals and income requirements within the ‘wrappers’ (General Investment Account, ISA, investment bond, pension) that you need for tax-efficiency. Assigning your capital to these different wrappers, each of which will have advantages and disadvantages for you depending on your circumstances and tax position, is part of our financial planning service.

Under our ongoing advisory service, we review your goals and circumstances regularly, and can adjust the risk-return characteristics of your investments, and your holdings within the different wrappers, as necessary.

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