3 Ways to Earn the Same Return With Less Risk
If you're sceptical about this headline, I completely understand.
In our everyday course of business we are constantly assessing investments, and we abide by the rule that if it sounds too good to be true, it probably is. That said, we believe there are three simple concepts you can employ to potentially earn the same return with less risk.
1. Focus on what you keep as much as what you make.
Taxes are one of the fastest ways to erode your returns. The benefit of high returns will be greatly impaired if you lose a substantial portion of those gains to The Tax Man. There are multiple ways to minimise taxation. Some of those options include:
Wrap your investments in a tax free cloak – ISAs, pensions and (perhaps) bonds.
Limiting your ordinary income generation in taxable accounts and/or gearing your taxable investments towards capital gains
Using your spouse’s allowances as well – (getting married is always a good idea for tax).
If your average investor, with a portfolio of 60% stocks and 40% bonds, were to employ a strategic approach to the taxation within their portfolio, and reduce their tax drag by what might appear to be a marginal amount by adding just 1/2 of a percent of return per year to their after-tax return, they could actually afford to reduce their equity allocation. The added benefits of reducing the equity allocation would mean the investor may experience a less volatile portfolio and yet have the same terminal portfolio value on an after-tax basis. Less risk for the same (or even higher) reward.
If you have less tax on an investment you can have lower growth for the same return. If you are happy with the same net return, that means you can afford to take less risk with your money.
2. Be mindful of costs. You need to receive value for your fees.
According to research the average cost for an equity mutual fund in 2016 was 0.63%. While that figure is down significantly from 1.04% in 1996, the difference in cost from an index mutual fund is still a healthy 0.40%, based on the average index fund costing 0.23% in 2016.
If our average investor replaces their higher-cost, actively managed mutual funds with lower-cost index funds that have largely captured the same amount of return as their active brethren (per Morningstar’s Active/Passive Barometer), we could potentially target keeping another 0.4% of return per year. Once again because our hypothetical investor would pay less in fees for the potential same return, they could afford to reduce their equity allocation.
Unless you are driving a Morris Marina please don’t confuse cost with value: as Mr Buffett succinctly put it, ‘cost is what you pay, value is what you get’. If you buy your own wine for home, you know this already.
The big champion of low cost index investing is Vanguard of the US – it was created by the late, great Jack Bogle – what’s not well known is Jack’s son runs a hedge fund and Jack was a key investor. (Do as I say…?)
3. Diversification beyond stocks and bonds.
Diversification may be the most overused word in the investment industry and yet, you would probably receive several hundred different descriptions of it if you spoke to 1,000 individual investment advisors.
In a nutshell, the two most common ways to depict diversification are to show a client a pie chart with several different colours or to highlight the amount of stocks and bonds an investor owns.
My team and I believe investors need to be diversified by more than a simple stock/bond mix. We advocate that a good portfolio is diversified based on risk factors such as company risk (too much in one company or overlapping bonds/stocks in the same company), interest rate risk (risks that arises for fixed income holdings when interest rates fluctuate), purchasing power risk (value of an asset suffers erosion from inflation) and manager skill risk (you have the right horse i.e. area of the market, but the wrong jockey). In total, diversifying by risk leads to what we refer to as “effective diversification.”
An investment in a single investment trust such as Murray International means you are invested in everything from UK gilts to Taiwan superconductors to Indonesian soap and Mexican airports –that’s probably enough diversification for most investors.
Unfortunately, too many people at Lehman Brothers, Enron, Northern Rock and Barings had a front row seat to the issues that arise when you have too much company risk. While it might be unfathomable for shareholders or employees of today’s darlings, such as Apple, Zoom, Facebook or Tesla, we would all do well to remember the damage endured by those that had too much exposure to one company in the past. Using effective diversification is one more step an investor can undertake to lower their portfolio’s equity allocation and volatility simultaneously.
If our average investor with a 60/40 portfolio were to employ these strategies, and decide to reduce their equity allocation by 15%, to arrive at a 45/55 portfolio, when the next 30% stock market dip occurs--and there will be another 30% loss in the future-- the equity portion of their portfolio would only fall by 13.5% instead of 18%.
There are certainly other ways to seek more return or equal returns with less risk. In our experience though, three methods that could potentially maximise risk adjusted returns involve employing proper tax planning, being mindful of fees and allocating assets to achieve effective diversification.
Be sceptical, we are; as planners we have a real legal and responsibility for ensuring you only hold suitable investments, and that you hold them in the right amounts and right accounts.
Beware of short cuts, after all, haven’t you just spent 40 years working to diligently squirrel away money into pensions and savings – don’t make the mistake of thinking that because now you have an accumulated sum the investing is easy. It’s not, and once you’ve stopped work you can’t afford to get it wrong – once it’s gone, it’s gone, so if ever you have needed it, now is probably the most important time to take professional advice.