Portfolio diversification

Managing the risks you are exposed to in order to avoid suffering losses to your capital

Whether you’re planning to start investing your money, or even if you’re already a seasoned investor, it’s crucial to make sure you manage the risks you are exposed to in order to avoid suffering losses to your capital. The key is to build a diverse portfolio with a mix of different investments that makes sense for your attitude to risk.

A balanced investment portfolio will contain a mix of equities (shares in companies), government and corporate bonds (loans to governments or companies), property, and cash.

Assets moving independently
Having a mix of different asset types will help you spread risk. It’s the old adage of not putting all your eggs in one basket. The theory behind this approach is that the values of different assets can move independently and often for different reasons.

Shares move in line with the fortunes and prospects of companies. Bonds are most prominently influenced by interest rates, and property values, while also influenced by interest rates, are also more closely connected to the performance of the domestic economy.

Get the right asset allocation and you could make a healthy return, while also protecting yourself against the worst downturns in individual markets.

Different investment sectors
Say you held shares in a UK bank in 2006. Your investment may have been very rewarding, so you decided to buy more shares in other banks. When the credit crunch hit the following year, sparking the banking crisis, the value of your shares in this sector (financials) would have tumbled.

So, once you’ve decided on the assets you want in your portfolio, you can diversify further by investing in different sectors, preferably those that aren’t highly correlated to each other.

For example, if the banking sector suffers a downturn, this will not necessarily have an impact on the precious metals sector. This helps to make sure your portfolio is protected from dips in certain industries.

Some investors will populate their portfolios with individual company shares directly, but others will gain access to different sectors through managed funds like unit trusts and OEICs (open-ended investment companies).

Stock market movements 
Investing in different regions and countries can reduce the impact of stock market movements. This means you’re not just affected by the economic conditions of one country and one government’s economic policies. Different markets are not always highly correlated with each other – if the Japanese stock market performs poorly, it doesn’t necessarily mean that the UK’s market will be negatively affected.

However, you need to be aware that diversifying in different geographical regions can add extra risk to your investment. Developed markets like the UK and US are not as volatile as those in emerging markets like Brazil, Russia, India and China. Investing abroad can help you diversify, but you need to be comfortable with the levels of risk involved.

Range of different companies
Don’t just invest in one company. It might hit bad times or even fail. Spread your investments across a range of different companies. The same can be said for bonds and property. One of the best ways to do this is via a unit trust or OEIC fund. They will invest in a basket of different shares, bonds, properties or currencies to spread risk around. In the case of equities, this might mean 40 to 60 shares in one country, stock market or sector.

With a bond fund, you might be invested in 200 different bonds. This will be much more cost effective than recreating it on your own and will help diversify your portfolio.

Capacity for growth
Holding too many assets might be more detrimental to your portfolio than good. If you over diversify, you might not end up losing much money, but you may be holding back your capacity for growth, as you’ll have such small proportions of your money in different investments to see much in the way of positive results.

It’s usually recommended that you hold no more than 30 investments (be it shares or bonds). If you’re investing in funds, 15 to 20 should be a maximum.

Finally, for many investors – especially those without the time, confidence or knowledge to make their own investment decisions – professional financial advice is a must.

Investing for income

During these difficult economic times, one of the tools available to the Bank of England to stimulate the economy is interest rates. Lower interest rates mean that it is cheaper to borrow money and people have more to spend, hopefully stimulating the economy and reducing the risk of deflation. This is why the Bank of England has aggressively cut them.

If you are an income-seeker, much will come down to your attitude to risk. If you want no or very low risk, you may wish to consider a traditional cash bank account and accept that income levels are likely to remain low for the foreseeable future. However, if you’re further up the risk scale you may wish to consider some of these alternatives.

Gilts
If you’re willing to take on a slightly higher degree of risk and you need the extra income, you may wish to consider gilts (or gilt-edged stocks), which are bonds issued by the government and pay a fixed rate of interest twice a year. Gilts involve more risk than cash, because there’s a chance the government won’t be able to pay you back. It’s highly unusual for a government to default on a debt or default on the interest payments, so they have been considered safe. But in this current economic climate, this risk increases.

You are not guaranteed to get all your capital back under all circumstances. Not all gilts are bought from the government and held to maturity; some are bought and sold along the way, so there’s a chance for their value, and the value of gilt funds, to rise and fall. There are other types, such as index-linked gilts, which form the largest part of the gilt portfolio after conventional gilts. Here the coupon is related to movements in the Retail Prices Index (RPI) and is linked to inflation.

Corporate bonds
Next along the risk scale if you are looking for a higher yield are corporate bonds. These are issued by companies and have features that are exactly the same as gilts except that, instead of lending money to the government, you’re lending to a company. The risk lies in the fact that companies may go bust and the debt may not be repaid. They have a nominal value (usually £100), which is the amount that will be returned to the investor on a stated future date (the redemption date). They also pay a stated interest rate each year, usually fixed. The value of the bonds themselves can rise and fall; however, the fact that bonds are riskier at the moment means companies are paying more in order to induce people to buy their debt. There are an increasing number of global bond funds entering the market that may enable you to get value from a lot of different markets.

Equity income
If your primary objective is the preservation of income, you may not consider the stock market as the obvious place for your money. However, for investors who are prepared to see their investments fluctuate in value while hopefully providing a stable income that grows over time, you may wish to consider equity income funds. These invest in shares, focusing on the big blue-chip firms that have a track record of good dividend payments. The dividends will be your income.

Global equity income funds
Further up the risk scale are global equity income funds. These are similar to UK funds, except that there are only a handful of the big blue-chip firms that pay reliable dividends in the UK, whereas global diversification offers a significant range of companies to choose from. Investing in other currencies brings an added level of risk, unless the fund hedges the currency.

Equity income investment trusts
Equity income investment trusts are higher risk but similar to other equity income investments. They are structured differently from unit trusts and open-ended investment companies. Investment trusts are closed-ended. They are structured as companies with a limited number of shares. The share price of the fund moves up and down depending on the level of demand, so the price of the trust depends not only on the value of the underlying investments but also on the popularity of the trust itself. In difficult times, when investors are selling up, trusts are likely to see their share price fall more than the value of their underlying investments. This means they also have more potential for greater returns once better times resume. Investment trust share prices are therefore often at a ‘discount’, or ‘premium’ to the value of the assets in the fund.

Offshore bonds

Utilising tax deferral benefits to minimise tax liabilities

Finding the right offshore investments can be a key factor in making the most of your wealth, and it’s not only for the wealthiest of investors. With a few well-advised decisions, you could broaden your investment portfolio.

If appropriate, offshore bonds may provide an opportunity for your assets to grow in a tax-free environment. They also allow you to choose when any tax liability becomes payable. There are a number of other tax benefits with offshore bonds, especially if you have spent time living abroad. But they are complex structures that require professional financial advice.

International finance centres
While many investors will be aware that investing in an Individual Savings Account (ISA) or pension can help reduce their tax bill, you may be less familiar with offshore bonds. Like pensions and ISAs, offshore bonds are effectively ‘wrappers’ into which you place your investments, for example, funds or cash. They are offered by life insurance companies which operate from international finance centres.

The main tax benefit of investing in an offshore bond is gross roll-up. This means that any underlying investment gains are not subject to tax at source – apart from an element of withholding tax. With an onshore bond, life fund tax is payable on income or gains made by the underlying investment. This means your offshore investment has the potential to grow faster than one in a taxed fund.

Tax deferral
As long as investments are held within the offshore bond wrapper, you don’t pay any income tax or capital gains tax on them, and you can switch between different funds tax-free. While you do have to pay tax on any gains when you withdraw assets, there are a number of ways you can potentially reduce the amount you pay.

You can withdraw up to 5% of your initial investment every year for 20 years, and defer paying tax until a later date. If you are a higher-rate taxpayer now but expect to become a basic-rate taxpayer when you retire, you can defer cashing in your assets until retirement and possibly pay half the tax due on any gain realised.

New owner’s tax rate
You can assign (transfer ownership) an offshore bond – or parts of it – as a gift without the recipient incurring any income or capital gains tax, although this may cause an Inheritance Tax (IHT) liability if you were to die within seven years. All future tax on withdrawals will be charged at the new owner’s tax rate, if any. This can be a tax-efficient way to help fund your children’s university fees, for example, since your children are likely to be low or non-earners as students. Putting an offshore bond in a trust could help your family reduce or avoid IHT, provided you live for seven years after setting it up.

Understand each jurisdiction
Investor compensation schemes tend not to be as developed as in the UK, so you should always obtain professional advice to ensure that you fully understand each jurisdiction. It is also important to ensure that you are investing in an offshore investment that is appropriate for the level of risk you wish to take.

If you are an expatriate, you should make sure that you are aware of all the investment opportunities available to you and that you are minimising your tax liability. Investing money offshore is a very complex area of financial planning, and you should always obtain professional advice. Currency movements can also affect the value of an offshore investment.

INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.

THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.

PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.