How to avoid the pitfalls of risky investments

It’s not something that Irish investors have typically excelled at in the past; building a balanced, diversified portfolio that will see your investments soar in the good times – and survive the inevitable bear markets.

However, as all too-painful recent experiences have shown, taking a holistic, broad-based approach to your investments can ensure that while returns may not always be stellar, losses can be contained.

After all, it’s your money, and you won’t want to lose it. It’s an approach Irish wealth managers have actively embraced since the downturn.

Indeed, Adam Cleland, head of wealth advice with Davy, notes that a restructuring in 2009 saw the stockbroker add two new arms: an investment strategy team, whose focus is to take a macro view of the world; and a portfolio construction team.

“Now there is an increased focus on where investments sit with other investments,” he says, adding it’s part of a greater swing towards financial planning, wherein investors are asked to consider their risk/return profile, and what their ultimate goal is.

“It’s an over-arching framework – what the total portfolio is trying to achieve and what risk you’re going to take.”

For Daniel Moroney, an investment strategist with Investec, putting a plan in place is key. “This sounds obvious, but a lot of people invest their savings without any specific objectives or time-frame in mind”.

An objective can be saving for a rainy day, a college fund for your children, or your own retirement. But understanding your goals and time horizon is essential.

Generating growth vs generating an income

For income-investors, life used to be so much simpler, with both bonds and deposits offering a decent return on your money. Now however, with interest rates still on a downward spiral, if you’re looking for a low-risk, steady return, you won’t find it easily.

But as Moroney notes, the danger then is that in an attempt to earn income, investors stretch too far into low-quality, risky investments and put their capital at risk.

“This situation illustrates how the current environment is fraught with danger for traditionally ‘conservative’ investors.”

Cleland agrees, arguing that in the search for yield, investors may inadvertently take on more risk than they’re comfortable with.“The challenge for investors is they’re not getting paid much return, so there is more of an onus on growth /alternative assets,” he notes, adding that options tend to be more exotic-type bonds, “but that can be a dangerous space”.

So what should they do?

If they stay in cash earning negligible interest, the risk is that inflation will eat away at the real value of their money

The other option is to allocate a certain proportion of their portfolio to riskier, higher-yielding assets – but such an approach needs to be carefully considered.

“It is critical to have a well-thought-out plan that is suitable for the individual. Realistic expectations must be set from the outset,” advises Moroney. For investors with reasonably long-term time horizons, this opens up the option of taking a ‘total return’ approach to income.

“This approach involves constructing an investment portfolio and using a combination of yield and asset sales to meet income requirements over time,” he adds.

Responding to “noise”

But once an investor has a plan in place, what should they do when the Brexit vote happens and their share portfolio plummets, or the European Central Bank announces more quantititative easing and the yields on bonds fall. Should they react?

“Financial markets will always be volatile – there is nothing unusual about that, it’s a normal characteristic of markets. Nevertheless, when normal bouts of volatility/weakness occur, investors are prone to overreaction,” warns Moroney.

Cleland adds many people believe that to be a successful investor they have to time the market well, by getting out before it falls, and getting back in before it rises again.

“In reality that’s really hard – most returns come for those who sit in it.”

So, while investors should be cognisant of what’s going on, “they’re right not to let it dictate their long-term plan”.

“In order to earn reasonable long-term returns, it’s imperative that investors resist the urge to overreact to short-term market swings. Overactivity leads to underperformance,” warns Moroney, adding that it comes back to the importance of having a plan and a clear idea of their end-goals. “Simply put: if you don’t have a plan, you have nothing to stick to.”

Re-balancing

But this doesn’t mean that your portfolio should never change. “You set your plan for the future and where you’re going to be, but it has to adjust as your own circumstances change and as asset classes move,” says Cleland.