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TaxationWeb by Bob Fraser MBA MA FSFA

To mark the launch of TaxationWeb’s ‘Tax Efficient Investments’ section, Bob Fraser, MBA, MA, FSFA, Associate Investment Director of Rensburg Investment Management Limited, outlines some ‘building blocks’ of good investment strategy.Too often investment attention is focused on headline performance statistics, and not the underpinning fundamentals. The aim of this article, therefore, is to re-emphasise the building blocks of a good investment strategy. Few individuals will have one all-encompassing strategy. They may have one for their pension plan, another for their ISAs, a third for children’s savings, and a fourth for a share portfolio.

Understanding Risk

The first essential is to appreciate the significance of risk. There are several types of investment risk, but most people are concerned with market risk, i.e. the possibility that you might not get back the amount you originally invested. Risk needs to be managed since it cannot easily be avoided. Even cash held on deposit is at risk, since its real buying power can be eroded by inflation.

Inflation risk is most devastating over long periods of time. So the first step is for the investor to decide the level of risk (s)he is happy with for that particular investment.

All Investments Carry Risk

All investments involve some degree of risk. As a general rule, investments that have the highest potential return also carry the greatest level of risk. Risk can be viewed as a pendulum, with risk on one side and reward on the other. The pendulum can swing high on the reward side, but equally high on the risk side. The degree of the swing is the ‘volatility’ of the investment. The assessed time it takes for the pendulum to complete a cycle (this will always be a guess) is also important as this sets the investment horizon. Low volatility investments can have a shorter investment period than higher risk ones, where the normal investment period should be 10 years. The investment horizon should be driven by the period of time after which the investment proceeds will be needed, and this in turn will determine the level of risk that can be taken.

Asset Classes

Investments will comprise one or more of the following ‘asset classes’:

• CASH - bank and building society deposits

• FIXED INTEREST SECURITIES - gilts and corporate bonds

• PROPERTY - commercial and investment property (either held as brick & mortar or as part of a collective investment)

• EQUITIES – shares or collective investments (ISAs, investment bonds, etc)

Diversification

Not all asset classes carry the same risk, and not all respond to the same conditions or at the same time. The degree to which the returns on these assets react to the same stimuli is called correlation. Non-correlated assets react to different stimuli. For example, sales of umbrellas will rise in rainy weather and fall in sunny weather. Sales of ice-cream should demonstrate the opposite trend.

In order to construct an strategy which begins to manage risk, it is important that the investment is divided among a variety of assets. This ‘diversification’ helps to reduce risk because different assets should rise and fall independent of each other, particularly if they have been selected on the basis of non-correlation. The aim of these combinations of assets is to cancel out each others’ fluctuations, therefore reducing risk.

Asset Allocation

This process of combining assets is called “asset allocation”, and its importance was recognised in the Sandler Review. ‘The asset allocation decision is by far the most important factor in determining long term returns.’ (Sandler Review: Medium and Long-Term Retail Savings in the UK – July 2002).
This asset allocation should reflect your total investments, and not just the components of, say, your ISAs. The reason is that unless you look at the complete picture, you may end up over or under-invested in one particular asset or sector.



Clearly, as time goes on the returns from the different assets will distort the composition of the asset allocation, so periodic reviews will be needed to rebalance the allocation.

Review

The investment process is not static, and conditions may alter unexpectedly or fund not perform as anticipated. Furthermore, personal circumstances do change. There should consequently always be at least an annual review to re-assess the basis of previous decisions. This review should be against the backdrop of an agreed benchmark, such as the sector average for collective funds or an index.

Steps to an Investment Strategy

So the following steps are necessary to establish an investment strategy:

• Establish your attitude to risk

• Decide the investment period

• Agree the optimal asset allocation

• Diversify across low or non-correlation assets/sectors

• Rebalance portfolio annually

• Set benchmark for performance measurement

• Review the above on regular basis

If this is not how your investments have been constructed, then you may wish to seek independent, qualified financial advice.

March 2005

Bob Fraser, MBA, MA, FSFA
Associate Investment Director
Rensburg Investment Management Limited
Contact Bob Fraser

Bob Fraser is an associate investment director and has achieved the highest level of professional advisory qualifications in the financial services industry. He is a Fellow by examination of Personal Finance Society, which is a specialist faculty of the Chartered Insurance Institute. He also holds a Masters of Business Administration degree.

Rensburg Investment Management is the largest company in the Rensburg group and a subsidiary of Rensburg plc, a public company whose shares are quoted on the London Stock Exchange. Its core business is investment management and it currently looks after around £3.0bn of funds for private investors, trustees, charities and pension funds. It provides independent financial planning advice and investment management services to both individuals and businesses in order to meet their financial objectives. Financial planning is the process by which resources and risks are firstly identified and then used or provided for in a way which best achieves financial goals and lifestyle. It provides detailed advice to clients across the whole range of financial planning issues from the provision of straightforward life assurance, to savings and retirement planning, to complex inheritance tax planning arrangements.

Rensburg is authorised and regulated by the Financial Services Authority (FSA) whose function is to provide investor protection through the regulation of financial product providers in securities and derivatives business.

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