Blogs | January 19, 2015

Are there sound proportions to use to split money between risky and less risky investments?

Christian asks: Since the financial crisis, many people are taking less financial risk. Are there sound proportions that investors should use to decide how much to put into different types of risky and less risky investments?

Ian answers: Christian, your observation that investors are less willing to take risk since the financial crisis is probably correct. However, your full question asks whether there are “sound proportions” for investing in “various financial services contracts” such as credit, home and life insurance and saving accounts. An implication is that investing is complex with the need to weigh up many options. However, I do not think that implication is correct.

Am I forever changed?
The global financial crisis that started in 2007 took a toll on many people, with jobs numbers and share and house prices plummeting in many places, creating an environment not seen since the Great Depression of the 1930s.
Evidence tells how shocks of this scale influence the behaviour of people, with investors often taking less financial risk. Attitudes are said to change even for those who did not suffer a financial loss. This can last a lifetime, due to an effect known as scarring.

How much risk to take
Investing is highly dependent on individual circumstances, so there is no “one size fits all” answer I can give.
However, there are some general wisdoms that might apply.
One of the first lessons of investment theory is that the amount of financial risk taken can be controlled by increasing or reducing the percentage of the total amount invested in a low risk asset. Assets at the lower end of the risk spectrum are government bonds ( with a ten-year government bond potentially suitable for a ten year investment horizon) and cash (suitable if money may be needed quickly).
eZonomics contributor Chris Dillow argues this decision around how much to put into low risk investments is crucial and should be done before considering which risky investments to buy.
“Other decisions, such as which shares or funds to buy, are secondary matters,” according to Dillow.
A common “rule of thumb” in personal finance is to allocate “100 minus your age” of your investment portfolio to shares inferring a proportion equivalent to your age held in low risk investments, however, as this article explains there is widespread debate as to if such guidelines are smart enough to apply to individual circumstances.

Which risky assets to buy
Finance theory also helps us understand how the risky part of an investment should be constructed. It says the average investor should hold risky assets in the same proportion as in the overall market for risky assets.
For example, if at a global level the market value of shares is $50 billion, bonds $25 billion and credit instruments $25 billion, the same proportions can be followed at an individual level.
That translates to a person holding something like 50% in an index tracking global shares, 25% in an index tracking global bonds and 25% in an index tracking credit instruments.
But without access to information about the size of each of these risky markets and the time and understanding to put this strategy into place, it will be difficult to follow this theory.
For most people, however, investing in a mix of global equities and global bonds is often sufficient.
Consider following a lifecycle approach to determine the appropriate mix of shares and bonds over time. If shares are the only risky asset, a passive fund that tracks a global stock market index is a good idea. A global index avoids home bias that can come into effect with only a domestic index.

Not everyone is average
There is one important reason to move from this general advice – if you are not average.
As John Cochrane, a professor of finance at Chicago University explains in a 1999 paper, when someone’s individual risks differ significantly from the average person, their choices should reflect that.
For example, a person running a property business (think of an estate agent or a self-employed builder) is heavily exposed to property prices and probably a downturn in economic growth. As a result, a “sound weighting” of risky assets for that individual would have less exposure than the average person to property and shares that would fall in price if growth slowed.
Most people, however, do not differ greatly from the average.
For most, index tracking funds of global shares and bonds will be sufficient.
It should also go without saying that, when choosing assets, reduce fees and taxes paid as much as possible.

Do the basics
Before even considering investing, however, don’t forget the basics. Know how much your household earns and spends.
Make budget.
Put in place systems to help you stick to that budget.
Insure what is important to you.
Provide for the time when you may want to stop or reduce the amount of work you do.
I assume, Christian, that you have these basics in place. If so, investing will be less stressful and more fun because the really important financial decisions will have already been made.

InvestingSharesRiskBondsEmergency savings

Ian Bright
Ian Bright

Senior economist at ING
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