What do we mean when we talk about portfolio rebalancing?
Imagine Dr Jones is a dentist who has four types of asset – cash, equity, residential property and commercial property. This year, although cash investments will have stayed fairly constant, equities (i.e. pension funds and ISAs) may have fluctuated, as they can be linked with stock market funds, and the property values might have fallen or spiked (something we are currently experiencing).
Therefore, Dr Jones’ portfolio may no longer reflect his attitude towards risk as it once did, and thus the process of rebalancing should take place. A balanced portfolio is one where the current attitude towards risk is adequately reflected in the asset portfolio.
Creating a risk profile is the underlying key to this process and an independent financial adviser (IFA) will analyse your risk scale, to ensure apples are being compared with apples.
Generally, a scale of one to 10 is used, with five representing a balanced attitude towards investment risk. A series of carefully crafted questions will determine the level of risk you are prepared to take, so the portfolio can be built accordingly.
The risk factors
With risk comes reward, and broadly speaking with investments, the lower the risk the lower the return. For instance, if Dr Jones invests into a bank account, he knows that his hard-earned money will be there (subject to certain criteria) year-on-year, attracting a small amount of interest annually.
However, when you take into account any tax that is charged on the interest and the effect that inflation has on the deposits, it is likely that Dr Jones’ money has fallen in value. Therefore, for the medium- to long-term, if you are guaranteed to lose ‘real’ money, it could be argued that bank accounts are high-risk investments!
As you can see from the example above, risk is always subjective, hence the importance of implementing a scale process that removes any potential grey areas.
Another example of this could be Dr Smith; she feels that she is reasonably cautious when it comes to investment decisions. This could be because all her family and friends spend a considerable amount of time investing in ‘higher risk’ investments, such as futures or buying and selling currency. In her opinion, and amongst her peers, she might be perceived to be cautious, even if Dr Smith was actually a seven on this scale and an adventurous investor.
This analysis is invaluable for ascertaining what your actual risk is, rather than telling your IFA that you are ‘middle of the road’ – after all, most of us don’t like to stand out from the crowd!
After this process has been completed the IFA can’t guarantee that they will make money, but what they aim to do is maximise returns, minimising losses on a year-on-year basis.
Perhaps in one year Dr Williams, who is a five on the risk scale, sees his equities double, pushing that side of his portfolio up to a six. After completing the risk assessment process again, Dr Williams’ portfolio will be ‘overweight’ in equities. It would now need rebalancing to reduce this overexposure to risk.
Building a risks profile
An IFA will take responsibility to make sure your risk profile is perfect with the investment and the funds themselves within your portfolio, and then it’s over to the fund manager to select the most appropriate companies within these sectors.
Selecting which investment firm to invest in is a bit like choosing which supermarket to shop in – you make a decision based on what’s right for you, be it convenience, cost, brand, size and so on. An IFA will select the best ‘funds supermarket’ to suit your needs and requirements. But just as people change where they buy their groceries, this also happens with the ‘funds supermarket’.
A risk profile will be reviewed depending on the size of a portfolio. Anything up to £200,000 would ordinarily only need reviewing once a year – however, any amount over this will require more attention as a small shift in percentage terms can have significant repercussions.
There are, of course, many other variables to be mindful of within a portfolio. For example, Dr Hughes might purchase a buy-to-let property (BTL) for £200,000, with a mortgage of £100,000. But it’s not simply a question of watching the rental income come in – he will have to be comfortable with the risks associated with that investment, such as if the boiler breaks down, or if the tenant leaves, both of which will require his attention.
This is where equities have an advantage over BTLs, because fund managers will be doing all the work, which reduces the hassle for investors.
Tax efficiency is another consideration – if you get penalised 40% on the gross return from your investments that would be pretty disheartening, to say the least!
There are ways of reducing tax risks by investing in some of the very generous tax efficient savings offered by the government, such as ISAs and pensions – again, it’s all about making sure the portfolio is properly reviewed.
Furthermore, special circumstances like retirement or a wedding might mean a segment of your portfolio is earmarked in more cautious funds. As you become more comfortable with how investments work, you will know what level of risk you should be taking for each segment of your portfolio.
Good professional advisers are worth their weight in gold, so make sure you work closely with your IFA as they will know how important it is to keep your portfolio in sync with the level of risk you’re comfortable with. The bottom line is that it’s your money – you will want to know that it’s working as hard as it can for you.
Richard Lishman is managing director of Money4dentists, a specialist firm of independent financial advisers that help dentists across the UK manage their money and achieve their financial and lifestyle goals. For more information, visit www.money4dentists.com