BEFORE starting to invest it is always wise to think about the return you require and the level of risk you can tolerate.
There are two other factors that need to be taken into consideration: first, your time horizon and, secondly, your capacity for loss: the consequences of your investment plans going adrift.
As a rule of thumb younger people have a longer-term horizon and can tolerate much higher risk levels in longer-term investments such as pensions.
It is a mistake for someone decades away from retirement to invest conservatively simply because they are risk averse.
On the other hand, you have to be realistic about the possibility of loss when your investment horizon is short and increase the exposure to low-risk assets.
You also need to consider what the impact on your lifestyle would be if things go wrong. For example, if you are a high earner saving for a bigger home and the investment does not work out you may have to work a little longer or harder to achieve your objective but your existing lifestyle will not be affected.
On the other hand, if you are in retirement and things go wrong you can no longer earn your way out of trouble.
Therefore, if your fall-back position is weak you can’t afford to take much risk.
Even with these simple parameters you can see that it is not easy to determine how much risk to take.
One popular rule of thumb is to take your age and subtract it from 110 to determine the percentage of your investments that should be in riskier assets like shares.
You could modify that rule a bit by adjusting the number up or down depending on your own attitude to risk and investment objectives.
Once a basic split between risky assets such as shares and defensive assets such as bonds has been determined the next main factor to consider is portfolio diversification to reduce risk.
All too often investors concentrate on their home market when it would be better to adopt a more global approach.
True, this introduces currency fluctuations into the mix, but these contribute diversification benefits that outweigh putting all your eggs in one basket.
It is therefore appropriate to have an exposure to global investments.
Many people will overlay their strategic asset allocation with their tactical market views and might for example underweight the UK if they fear the economic impact of Brexit or overweight it if they think Brexit fears are overdone.
Higher-risk shares can be balanced with a portfolio of defensive assets.
Traditionally this has been comprised of fixed-interest investments with a healthy exposure to government debt, such as UK gilts and US Treasury bonds.
However, following quantitative easing they no longer look cheap and many would argue they may not provide much defence when the economy takes a downturn.
Corporate bonds should also be in the mix as they are a halfway house between government debt and shares, and provide further risk-reducing diversity.
Because many assets have risen in recent years investors have turned to an array of alternative assets they perceive to offer better value.
A good example is commercial property, but don’t forget that many people already have a high exposure to property via their own home - don’t overdo it.
Absolute return funds, which are designed to provide positive returns during all market conditions, have been popular. Unfortunately, they have not lived up to the hype and it has been difficult to find consistent performance, though they still have their place.
A modest exposure to gold can be useful as it is normally a good hedge against inflation and geopolitical crisis.
Finally, when it comes to income generation it is often best to cream off the profit from a diversified portfolio rather than chase after potentially risky higher yields.
David Thomson is chief investment officer at VWM Wealth.
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