It's easier than you might think. This decision is: how should I divide my wealth between safe and risky assets?
The power of three – applied to risk
Back in 1969, Robert Merton – who was later to receive a Nobel Prize for economics – derived a simple formula to weigh risk and return. The proportion of wealth you put into the risky asset, he said, should depend upon just three things: the volatility of that asset; the difference between likely returns on the risky asset against the safe asset; and your attitude to risk. He claimed nothing else matters. These three things, however, raise a few questions.
"What is my attitude to risk?"
To derive attitude to risk, let's do some sums. Let's say you can get a 2% annual return on a safe asset and 5% on a risky asset, which we'll assume to be shares.
These numbers imply that if you split your money 50-50 between the safe asset and shares, the expected return on your wealth will be 3.5 per cent a year. But obviously, there are risks around this. Some simple sums – derived from the historical volatility of shares – tell us that you face a 10% chance of losing 9% of your total wealth or more over a 12 month period.
If this strikes you as too big a risk, consider holding fewer shares. If you're comfortable with it, though – and think a 3.5% gain is too small – then consider holding more shares.
"What is a safe asset?"
The second question is about what constitutes a safe asset. And the answer is "it depends". If you're saving for a long-term objective – say to retire or to pay your children's university fees – then the safe asset is one that has a known return on the day that you'll need the money. This could be an index-linked bond that matures on the date you'll be spending. I say index-linked because this protects you against unanticipated inflation.
If, on the other hand, you need savings to protect you against unforeseen emergencies - your boiler blowing up or losing your job – then the safe asset is cash, something you can get immediately. One of the key rules of investing is: never be a forced seller. Hold enough cash to ensure that, if bad times come, you are not compelled to sell riskier assets, be they shares, property or something else. You rarely get good prices in such circumstances.
"What are risky assets?"
Shares and commodities are the obvious answers to the third question about what are risky assets. But if you regard your house as part of your savings – say, if you plan to sell it to partly fund your retirement – then you should also include it in the basket of risky assets. Strictly speaking, we should also include your human capital – your earning power – in the bundle of risky assets. If you own your own business, this also counts.
What matters, remember, is your entire wealth.
This complicates matters slightly. If your house price moves up and down as share prices do then you might need to hold fewer shares than you otherwise would. Similarly, insofar as there is a risk of you losing your job or business at the same time as the stock market falls, then shares are also riskier for you than for the average investor.
ING Group chief economist Mark Cliffe said in his sixth video lesson from the financial crisis that traditional diversification "didn't work" in the downturn because "just about everything fell at once". Government bonds and cash "were the only place to hide".
"What are likely returns on risky assets?"
It's easy to be tempted by stories of double-digit returns on wine, stamps or commodities. But take heed. High returns can only come in two ways. They might be a reward for taking great risk – one such risk being that they might be hard to sell in tough times. Or they might arise because the asset is under-priced. But if this is the case, just ask: why is this guy selling it to me, rather than buying it for himself?
As a rule, do not expect any asset to deliver returns of more than 4-5 percent after inflation.
Get the split between safe and risky assets right
A good wealth manager should help guide you through these issues, and so come up with a split between safe and risky assets that suits you. Alternatively, you can make this decision for yourself.
Just remember that shares and commodities are very risky – as a rule of thumb, assume there's a 10 percent chance of losing 20 percent over a 12 month period – and that their likely average excess return over cash will be only a few percentage points per annum over the long run.
The key thing, though, is to get this split between safe and risky assets right – in the sense of having a balance that suits your tastes and circumstances. This is the first thing you should do in managing your money. Other decisions, such as which shares or funds to buy, are secondary matters.