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Risky business: Don’t be tempted to confuse speculating with investing

In our socially connected world, it doesn’t take long for good news to spread.

Dec 18, 2020, updated Dec 18, 2020

Every day, you’ll read stories about people who’ve struck it rich (or simply got lucky) by taking a punt on the latest hot opportunity.

It might be a stock that’s tripled in value, or the latest digital currency that’s being heavily promoted online.

It doesn’t matter which; all you know is that somewhere, somebody’s making a stack of money, and it’s not you.

You might even think you’re missing out, particularly if your investments are still recovering from the downturn earlier this year.

You could be tempted to throw caution to the wind, and have a dabble in something hot.

Let’s just pause for a moment, and consider the difference between speculating and investing.

One way to describe speculating is taking big risks, hoping you’ll get a big payoff.

That’s not what investing is about. Investing is about managing risks, not embracing them.

One of the best ways of reducing investment risk is to spread your portfolio across a number of different investments, and types of investments.

It’s the old ‘don’t put all your eggs in one basket’ theory, and it’s stood the test of time as an important way of smoothing investment returns and reducing risk.

The main investment classes – cash, fixed interest, property and shares – all carry different levels of risk, and all have provided different returns over time.

Historically, shares have been the best performer. But those returns have varied from a 30 per cent gain in a good year, to a 50 per cent loss in a bad year. And nobody can predict which types of investments will perform best in the future.

At the other end of the spectrum, cash is safe (and there’s a government guarantee on bank deposits of up to $250,000).

But the return? In most accounts, it’s close to zero. If you take into account inflation, your bank return can actually be negative.

If you hedge your bets, and spread your portfolio across cash, fixed interest, shares and property, there’s the potential for losses in one class of investment to be offset by gains in another.

You won’t get the peak returns of the share market in a boom year, but neither will you experience large losses.

Overall, your risk is lower, and your returns will be more consistent.

Strategic asset allocation is the process of choosing the mix of investment types that will meet your investment objectives, while minimising risk. And the best asset mix for you will depend on your investment timeframe, and how comfortable you are with risk.

There’s no one fixed asset allocation – it will vary between individuals. A younger investor hoping to build wealth for the future might be comfortable with a high exposure to shares.

Somebody approaching retirement might be more cautious and balance their exposure to shares with higher levels of cash and fixed interest.

Setting a target asset allocation adds some discipline to your investment strategy. It means sticking to a process that will optimise your returns, rather than chasing the hot opportunities that could make you rich (or broke).

Just as there’s no thing as a ‘set and forget’ investment, your asset allocation needs some attention from time to time. At least annually, you should consider ‘rebalancing’ your portfolio.

In any year, some of your investments will perform better than others. Let’s suppose your original allocation to shares was 40 per cent and the market has a good year. You might find shares now make up 50 per cent of your portfolio.

Rebalancing involves reducing your exposure to shares back to 40 per cent. In other words, you’re taking profits from assets that have performed well, and topping up your other investments.

If you’re not sure whether your current asset allocation is right for you, or you think it might need rebalancing, talk to your Morgans adviser.

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