De-Risk Your Investments While Increasing Returns!

The basic premise of investing is that return is driven by risk: the higher the potential return, the higher the risk must be. This makes intuitive sense, but while it’s true for gambling, it’s not strictly true for all investing.

With stocks, the concept of risk has been muddied with the concept of volatility.

For the short-term trader placing a bet on the stock market, short-term volatility does make that a high-risk strategy. But for the long-term diversified investor, volatility does not translate into higher risk at all.

Here we’re arguing that the stock market is in fact the safest place for your money in the long term… and we’ve got some tips for how you can reduce your risk, without sacrificing any return!

What Goes Up Must Come Down

Every investor is familiar with the concept that the value of their investments might go down as well as up.

It is this fact that terrifies the common man and woman in the streets and keeps them from investing. Or put another way, it keeps them poor.

Why Time Takes The Bite Out Of Stocks

For a short-term trader, the time horizon is small, with the vast majority of the investment’s risk being due to short term volatility.

Remove that short-term volatility from the equation by investing over 30 years, and are stocks still a high-risk investment?

For the long-term investor, the main risk to your finances is not volatility, but the risk of you not hitting your retirement target by having been too cautious.

Look at any 30-year stock market period since the year 1900 and you will see an overall gain.

So long-term investors’ real worry should not be that their equities lose money, as it’s almost certain that they will make money.

Another legitimate risk is that you need access to that money at an inappropriate time, like during a market crash.

But if you have a good-sized rainy-day pot of cash to avoid being forced into selling during one of the market’s frequent low periods, then this risk is removed also.

What’s The Alternative?

We’ve covered many times how the alternative to investing – saving cash in a bank account – is vastly inferior in terms of returns.

As an incredibly brief reminder, once inflation plays its dirty hand, cash savings produce a negative real return; while stocks have always produced a positive one, long-term.

Holding cash makes you poor, in terms of real buying power, which is all that matters. In recent times the loss is around 3% each year; the rate of inflation. This soon stacks up over the years to destroy your position.

When looked at like this, a low or negative return obviously carries its own risk.

It’s far more likely that you will run out of money in retirement, for instance, if you don’t invest – or worse, you never get there because you have to work for decades longer than you wanted to because you didn’t take enough “risk” with your investments.

Low returns actually result in a higher risk to you personally. But high returns can be achieved through low-risk investing – you just need to point your money in the right direction.

How To Dial Down The Risk On Investments

We want a low-risk portfolio that gives us high returns. And we don’t think that’s too much to ask for.

Far too often though, investors are happy to just lower their perceived risk by slashing their returns.

There are profitable ways to lower risk; and there are overly cautious, loss making ways to do it. Let’s discuss these first.

The Wrong Ways To Reduce Risk

#1 – Diversifying With Too Many Asset Classes

Every conventional investing guru will tell you that you should hold a high percentage of bonds in your portfolio – often around 30% or so. Further still, they will probably tell you to also own gold, commercial property, investment trusts, currency, and maybe even crypto.

They advocate this approach because it reduces volatility.

The theory accepts as a necessary cost that some part of such a portfolio should be losing money in the next 12 months, as all assets won’t move in the same way.

But remember, as long-term investors, we don’t necessarily care about volatility – so long as we have a strong enough willpower to stare down any market crashes along the way.

Some of these asset classes are fine additions to a portfolio, and we ourselves own gold and property in addition to stocks.

But these additions are there to boost our returns – not to reduce volatility.

#2 – Focusing On The Wrong Risks

Investors can get hung up on the wrong risks. The main error is focusing on market risk – the risk of short-term losses across the portfolio.

First, you should only be investing money that you can afford to live without, so you can live with temporary losses while you’re building your portfolio.

And second, it is illogical to seek safe harbour in low performing asset classes like bonds or cash to limit losses, as you’re also limiting gains by doing this.

And history shows us that gains always outstrip losses in the end.

Another big worry for investors is currency exposure. But we think currency risk will likely balance out over the long haul, and trying to manage currency risk will often incur fees and produce lower returns long-term.

The biggest real risk you should be seeking to avoid is spending decades on an underperforming portfolio – and consequently retiring poor.

#3 – Reducing Equities As You Age

Most investment advice tells you to reduce equities as you age, to reduce risk (they mean volatility). This is despite equities – stocks, funds and ETFs – being the best performing investments without using debt as leverage. But even in retirement, we want our pots to be growing.

Retirement day is just a day like any other for our portfolios – nothing changes.

A safe withdrawal rate of around 4% can be applied to your equities, allowing you to draw an income and still see portfolio growth.

This is simply not possible if you start switching in large amounts of cash and bonds.

Positive Ways To Reduce Risk

There are positive ways to reduce risk within the stocks asset class, as a higher-return alternative to hiding behind bonds.

#1 – Not All Equities Are Created Equal

You’ll hear the words “stocks are risky” said as though all stocks were the same.

But does a water company carry the same level of risk as a high street retailer?

No – the water company is very low risk because everyone needs water – and water services.

The retailer’s fate is tied to the economy and the whims of fashion – recessions come and go frequently, taking many retailers with them.

We can diversify our portfolios to include lower risk equities instead of relying on low interest bonds.

To see how water has performed as an asset, the iShares Global Water UCITS ETF (IH2O) has returned on average 9.73% annually in the last 10 years – actually outperforming the iShares Core MSCI World UCITS ETF (SWDA) which returned 8.62% annually over the same time frame. Not bad for a low risk asset.

#2 – Dividends

You could also de-risk a portfolio as you approach retirement by moving your investments into high-dividend ETFs and stocks.

Good high-dividend funds can yield 5 or 6 percent, and tend to be more stable companies.

Dividends therefore help you to ride out volatility, though these low growth companies could be a hindrance while you are in the early growth stages of your portfolio.

Furthermore, you don’t need dividend withholding taxes chipping away at your wealth.

#3 – Wide Diversification Within Stocks

While over-diversifying between asset classes can be counterproductive for returns, it’s good to diversify within them.

If you own many thousands of stocks from every corner of the world and every industry, you are unlikely to be in a loss position for long.

As they say, there’s always a bull market somewhere. You’d still need to worry about worldwide market crashes, but only if you needed urgent access to your money.

Crashes tend to resolve themselves within a few short years or less.

What About Rebalancing?

Rebalancing manages the risk of your portfolio drifting away from your target allocations, by selling part of your best performing assets and buying more of the worst performing.

In most years this would mean selling overperforming stocks to buy more bonds.

The jury’s out on whether rebalancing gets you higher returns or not.

Some academic studies show rebalancing gives higher returns, through the act of selling high and buying low – and also through the act of taking small chunks of gains often to avoid capital gains taxes when held outside an ISA.

While others make the solid point that by continually selling winning stocks to buy loser bonds results in a lower return.

One thing it does do, is lower volatility. Remember that volatility and risk are not the same thing for a long-term investor.

Use The Headroom You’ve Built

If your portfolio is risk-efficient, so you are bringing home big returns for a low risk, it might be ok to increase your risk slightly by adding some individual stocks to pursue even higher returns.

Unlike funds and ETFs, it’s not unusual for a stock to double in value in just days.

Using a tool like Stockopedia can help you find well positioned stocks like this, and ones with low risk indicators like low net debt and solid earnings per share growth.

Anyone interested can trial Stockopedia using the link on the Offers page, free for 14 days – and then get themselves 25% off a subscription.

Are you sacrificing return to try and lower risk? Let us know your strategy for managing risk in the comments below!