An investment portfolio can be defined simply as where one keeps one’s money. If one chooses to keep all one’s money as cash in one’s bank account, then that becomes one’s portfolio. Definitely, it is not a smart investment portfolio. The interest one will be earning from the bank will probably be less than the inflation rate. Therefore, the value of money over time will decrease. Because of this reason, it is advised that one should spread one’s money around a few different investment instruments. Investment can be of different types based on the requirement of the investors. Some investors may want to achieve quick gain from investment. Some may want to invest their money for long term to secure their future. This essay will discuss how risk and return can be balanced for a 10 year investment portfolio worth £1.748 million. The essay will also discuss the effect of recession on different types of investment instruments.
Before taking decision on where and how to invest, it is important for the investor to understand the goal of investment, because the investment strategy for short term goals differ significantly from the investment strategy of long term goals. Investment strategy also depends on how long one wants to keep one’s money invested. Most investment strategies can be divided into three categories; short term, medium term and long term. In this case, the goal is to invest for at least 10 years so that the investor obtains a substantial amount of money after 10 years that can be used to maintain a good retirement lifestyle. In general, for long term investment, the more time an investor has in hand, the more investment risk he or she can take. However, from long term investment perspective, 10 years is a short period. Therefore, in this case, the goal will be to grow the money without taking much risk. The objective will be to invest 70% of the total fund in investment instruments that are of low to moderate risks. Rest 30% of the portfolio can be invested into high-growth and high-risk instruments such as stocks.
Understanding Different Instruments
The global financial market is extremely developed than it was 20 years back. Currently, almost all kinds of financial activities are converted into investment instruments. Starting from company stocks to commodity futures, an investor has a host of options to choose from. For a typical investor based out of the UK, the investment options can be broadly classified into four different categories; 1) cash and cash equivalents, 2) equity, 3) commodity and retirement instruments, and 4) bonds (Samolyk, Critchfield and Watson, 2007).
Cash and cash equivalents are the most common form of investment even though the return from this type of investment is almost nil. Still a majority of the population keeps a substantial amount of their income and savings in the form of cash in their checking account or savings account. Checking account often gives about 0% interest, whereas savings account gives an interest rate between 1% and 2% (depending on market situation) only. Still people keep their money in these instruments because the risk associated is very low and the money is highly liquid and accessible (Samolyk, Critchfield and Watson, 2007).
Equity market is one of the largest investment markets. A typical investor can invest in a single company stock or in a group of stocks. In the UK, an investor has options to invest in large cap growth, value, or blend stock portfolio. The investor can also invest in mid-cap or small cap equity. Typically, large cap stock portfolios have much less risks than mid-cap or small cap, because they consist of stocks of the blue chip companies. Apart from that, the investor can also invest in overseas market. The investor has the option to invest in very high-growth markets such as India, China, Thailand, South Africa, and Brazil. Investing in these emerging markets may produce high returns but that high return comes with higher risks. The investor can choose to invest in rather stable markets like Europe and the USA where the rate of return will be less, but the growth will be less volatile and risky (Otten and Reijnders, n.d)
The investor can also invest in commodities. In the UK market, there are several investment opportunities in the commodity market. One of the most traded commodities is energy, which mainly consists of oil, coal, and natural gas. However, energy commodities are extremely volatile. It may give an investor 100% return on investment within a year or two, but it can also go down pretty quickly. Among the commodities, precious metals index is one of the more stable investment options. Precious metals index is comprised of gold, silver, and other valuable metals. The unique feature of precious metals is that their price gets least affected by recessionary situations (Otten and Reijnders, n.d)
Bonds are the more secure way of investing for long term. Government bonds are the most secure. They may give an interest rate that is very low, but the investor can be rest assured that he will get the money at the end of the period for sure as sovereign default risk is very low. Corporate bonds are also relatively less risky, but give fewer returns. If the investor wants to invest in bonds and seeks a good return, then emerging market bonds are often a good instrument that has moderate to low risks, but give good return (Ahmad and Steeley, 2008).
Apart from these four major instruments, many investors look to invest in properties directly or through real estate investment trust (REIT). REITs own many types of real estate starting from office, warehouse, hospitals, shopping centers, and hotels. These REITs are modeled after mutual funds and these are available through stock exchange. REITs often give good return but they have higher risks involved in investment in the case of default. The main characteristic of REITs is that they appreciate in value faster than any other investment instrument when the market is performing well and is in high inflation scenario, whereas all the value gained in a property may decrease very quickly in recessionary scenario (Block, 2006)
Summary of Investment Instrument
In the previous section, I have discussed different types of investment instruments and their return versus risks. The below table shows the different types of investment instrument that will be used for analyzing the portfolio and its rate of return in the last 10 years. I have chosen the last 10 years average interest rate because it endured two recessions. One of these recessions happened in 2007 in the USA and another in 2010 in Europe. I will be using the interests rates marked below for the next 10 years as well, as I expect that one or more recessions will hit the world again sooner (Morningstar, 2015).
Performance on Different Investment Instruments during Recessions
Not all recessions are same. Therefore, different recessions may hit an instrument differently. I will try to look at majorly how 2007 recession influenced different types of instrument performance. Stocks are most easily affected by any recession.
Figure: Equity, Bond and Bills Yield (Credit Suisse Yearbook, 2013)
Figure: Historical Gold Prices (Thomas, 2013)
It can be seen from the above graph that gold prices are relatively resistant to recessions. Gold prices also show volatility, but that is not often due to market volatility. For instance, between 1990 and 2006, the overall global market grew at a fast pace, but gold prices during that period grew insignificantly, whereas between 2006 and 2011 when all other investment instrument were not growing at all, gold prices grew by almost over 100% within a matter of 5 years ((Thomas, 2013).
Figure: EU Bond Yields (Pettinger, 2012)
It can be seen from the EU bond yields that bonds are relatively less volatile than the market volatility. However, from the above graph, one can clearly see that bond yields are highly dependent on the financial health of a nation. For instance, the bond yields for Spain and Italy are very high because they were on the verge of bankruptcy a few years back and are still economically sound. On the other hand, Germany and the UK economy show much less volatility on the bond yields. Bond is a good instrument to invest upon in a recessionary market (Pettinger, 2012).
Figure: Brent Crude Oil Prices (ETF Securities, 2015)
Among all the instruments, energy commodity is one of the most volatile. It can be seen from the above graph that between 2008 and 2009 within a matter of a few months, the value of oil commodity eroded about 300%. This is an instrument that is preferred by investors who are looking for short term gains, but for long term investors, energy commodity may not be a suitable investment (ETF Securities, 2015).
In the table below, different types of investment instruments, their risks and economic profile are shown.
Investment Portfolio Analysis
As discussed in the previous sections that I have £1.748 at my disposal for investment. I will try to build a portfolio in which 5% of the total money available will be kept in cash and cash equivalents. 30% of the investments will be made in the high-growth and high-risk instruments and rest of the money will be invested in low to moderate risk instruments like bonds. However, building a portfolio like this on a standalone basis will not provide an idea about what the portfolio will gain or lose in comparison with very high-risk and very low-risk portfolios. Therefore, I built 5 different types of portfolios depending on the varying risk appetite of the investor.
Critical-Risk: 100% investment in a very high-growth single stock in India
Very High-Risk: 90% of the investment will be made in high-risk instruments such as emerging market stocks, small cap equity and mid-cap equity.
High-Risk: 70% of the investment will be made in high-risk instruments such as emerging market stocks, small cap equity and mid-cap equity.
Moderate Risk: 50% of the investment will be made in high-risk instruments such as emerging market stocks, small cap equity and mid-cap equity.
Low-Risk Profile: 30% of the investment will be made in high-risk instruments such as emerging market stocks, small cap equity and mid-cap equity.
Very Low-Risk Profile: No investment in risky instruments such as equity or commodity.
Using excel solver, I have made all the above portfolios by maximizing the targeted return on investment. The main constraints used for solving the problem are 1) percentage allocation according to the risk profile and 2) maximum 20% investment in a single type of instrument (to ensure diversification). The results are demonstrated in the table below:
My portfolio is well-balanced against currency appreciation and depreciation. In the case of pound appreciation, the domestic investment will protect the investment value whereas in the case of pound depreciation, overseas investments will fetch more money. The portfolio is also well-balanced in terms of risks. 65% of the investments are made in moderate risk instruments such as large-cap stocks, corporate bonds, and emerging market bonds, which protect the portfolio against any recession in the next 10 years. Therefore, upon analyzing both the return and risk profile, it can be said that the below investment profile will be good for the investors for the next 10 years.
The table above shows the percentage allocation and actual pound investment in each instrument.
After Retirement Fund Management
After retirement, the investor can put all his money into very secure securities and get the interest for regular expenditure. From the total fund, the investor can also keep 5% as liquid money in the case of urgent requirement of cash for health reasons.
The above table shows the annual income, inflation adjusted income (3% inflation assumed), and total liquid cash in hand for different scenarios. It can be seen that in this case, the investor will get an inflation adjusted income of £88,600.57 per year till the time he lives.
Portfolio investment is not as easy as it seems. Balancing a portfolio requires balancing against different types of parameters including risk, inflation, currency volatility, and recessionary crisis situations. Some instruments worked well in good economic conditions, but fail miserably during depressions (equity). Some instruments are risk-neutral and relative resistant to recessionary situations (bonds). There are other instruments influenced by other macro-economic conditions that may not be related to business situations or recessionary conditions (gold). It is important to include all these types of instruments in a portfolio to balance all types of risks. In this case, I have balanced the portfolio by investing in large-cap stocks, small-cap stocks, domestic bonds, international bonds, emerging market stock, and commodity.
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