Ian Quigley, director of Investment Strategy at Investec Wealth & Investment Ireland outlines five key questions to consider in devising an investment strategy.
So you have built up a significant sum and you are wondering how you might invest this capital. How much risk should you take? What is your tolerance for loss? What is your time horizon? Do you have sufficient income to cover your expenditure for the foreseeable future? Do you have any outstanding debts?
These are five key questions you must answer before even contemplating investing your hard earned capital.
The first, most important step is to establish what you are looking to achieve and whether this is indeed achievable. It is critical to have a sound investment plan. For instance, it would be unwise to invest your money in equities if you absolutely need that money in a year’s time. Despite what some commentators might say, nobody knows what is going to happen over the next few years. We can certainly establish a core thesis for what we think might happen but we cannot predict outcomes with complete certainty. If your investment time horizon is just one year, as underwhelming as deposit interest rates currently are, cash deposits remain the most sensible option.
If you are looking to grow your capital over a period of many years, you should consider investing across a range of assets classes, including equity, property and bonds. Splitting your money between asset classes will then depend on your ability and willingness to withstand periods of loss. Most importantly, once you have adopted a sound investment plan it’s crucial to stick to it.
When asset prices are rising it is easy to stick to a plan but during periods of stress it is much more challenging. If you take on ‘too much’ risk you may grow very uncomfortable during periods of market weakness and this may result in you selling at a loss at the worst possible time. Understanding yourself and your ability to withstand market volatility is essential.
If you have outstanding debts, including your mortgage, you must also weigh up whether you would be better served financially by paying off some of your debt. This will of course depend on individual circumstances but with current variable mortgage rates above 4%, we must ask whether we can achieve a higher after tax return from an investment portfolio.
Once you have established your willingness and ability to take on investment risk, the next step is to look at the available returns from the various asset classes. Despite strong gains in equity markets over recent years, we remain of the view that higher risk assets like equities and property offer the highest potential returns over the next few years and that cash deposits and bonds will likely deliver historically low returns.
This makes investing particularly tricky for savers and lower risk investors, who would traditionally invest in cash and bonds. Indeed, it is our view that traditionally low risk strategies may deliver below inflation returns for quite some time.
History tells us that in the aftermath of a large debt build up governments and central banks are incentivised to keep government borrowing costs below inflation in order to reduce the overall debt burden, resulting in a transfer of wealth from savers to borrowers. This is happening across the western world and we expect it to continue.
As a result, investors are being forced to take on more ‘risk’ if they want to earn a positive after inflation return. The key question for us as advisors then is whether it is appropriate for our clients to take on additional risk and if so are assets like equities and property reasonably valued?
Before expanding on this, it is probably worth considering exactly what we are talking about when we talk about risk. In financial markets, risk is defined as volatility i.e. how much an asset goes up and down. However, it is highly questionable as to whether this is the right way to measure risk. In our opinion, risk is better understood as the risk of permanent loss of capital i.e. the risk of not getting your money back.
This is a much better starting point when constructing your portfolio. Instead of worrying about which assets will go up and down the most, let’s focus on the assets that offer the best prospective return with the lowest probability of permanent loss of capital.
For example, when we look at equity markets today, we ask are they reasonably valued and what is the risk of permanent loss of capital? Our conclusion is that global equity markets are reasonably valued and provided we diversify sufficiently and we have a long enough time horizon there is little risk of permanent loss of capital.
This point is particularly relevant when considering a strategy for your pension fund. Investing through a pension fund remains the most tax efficient way of building up capital for retirement and this is where most investors should start. If you are relatively young and your retirement date is some way into the future, it would seem clear to us that you should have strong equity bias. If you are close to retirement your strategy should naturally be more conservative.
How investors should invest in equities, or indeed other asset classes, is an additional decision with the options including direct investment in stocks and collective funds. The taxation of the various strategies will also be a consideration but it should not drive the ultimate investment decision.
Over the past few years, it has been our experience that investors in Ireland have been too cautious in their investment strategy. In many ways ‘overlearning’ the experience of the 2008/2009 bear market. Of course this is entirely understandable given the destruction of wealth during this period and it is important to learn lessons from this period. However, it is also worth asking are investors making a different mistake now. Are investors being too cautious?
This is not to say that investors shouldn’t be conservative and prudent and we have to acknowledge that equity markets have been quite strong over the past few years. However, as we look forward it seems clear to us that some exposure to equities, and to an extent property, will likely be needed in order to generate positive after inflation returns over the next few years.
As we can see, there are many considerations when devising your investment strategy so it is important to reflect upon your circumstances and what your goals are. If you are well diversified and you have the right asset allocation, investing can be relatively stress free and rewarding over the long term. If you get this wrong it can lead to unnecessary anxiety. It is therefore very important to make the right decisions at the outset.
We recommend seeking the advice of a qualified advisor with plenty of experience to guide you on this path.
Ian Quigley is director of Investment Strategy at Investec Wealth & Investment Ireland. Quigley previously worked as a director of Wealth Management at NCB from 2004-2013, having joined as a graduate.
Quigley has a Degree in Economics from Trinity College Dublin and a Masters in Financial Services from the UCD Michael Smurfit Graduate Business School. He is also a member of Society of Technical Analysts and is a qualified financial advisor.