Historically, if we wanted to match or beat inflation risk over the long term we would have had to invest in equities. However, with equities, unless a fund offers a guarantee (and these can be costly), the individual’s capital certainly is at risk.
Diversification in mutual fund and within a portfolio in order to reduce risk at the total portfolio level. However, it is also important to be able to recognize the level of risk inherent in a financial product and this is not always apparent. Most of the major mis-selling scandals in the commecial financial services markets are a result of naivety and misunderstanding on the part of ETF investors, and the disingenuous desire to mislead on the part of providers and advisers.
The following benchmarks take a very broad-brush approach to investment, which provides a useful starting point to the assessment of an asset allocation class, product or scheme. It does not matter whether we are examining deposit investment accounts, collective best funds to invest, direct equity and bond investments or higher risk investments such as venture capital trusts, which invest in the shares of unquoted trading companies – measuring risk against certain benchmarks helps to keep a good overall perspective.
The benchmarks will also help students to focus on the important fundamentals as opposed to the ‘bells and whistles’, which are used so successfully in marketing literature to make products and services look more attractive, safer, tax break investment efficient or ethical than they really are.
- Aims: What are the stated aims and benefits of the investment? Do these fit in with the individual’s aims and objectives?
- Returns: Compare the potential net returns of the investment with after-tax returns on very low-risk products such as high-interest deposit accounts, short-term conventional gilts and National Savings & Investment low-risk products. Is the potential out-performance of the investment really worth the additional risk?
- Alternatives: Which other investments share similar characteristics? Are they simpler, cheaper or less risky?
- Investment period: For how long can the individual genuinely afford to invest the money? Compare this with the stated investment term and then check how the charges undermine returns in the early years. Check for any exit penalties and remember that a ‘loyalty bonus’ on an insurance product usually acts as a penalty in disguise if the individual does not continue the investment for the required period.
- Risk: What is the risk that the investment will not achieve either its own stated aims or the individual’s private objectives? What is the most he or she could lose? Is the capital and/or income stream at risk? What is the likely effect of inflation? How is the investment regulated? What happens if the firm investment manager defaults?
- Cost: Look at the establishment costs and ongoing charges. Remember that high annual management charges on collective funds, particularly for long-term investments, will seriously undermine the return. With direct equity portfolios watch out for the high transaction charges and turnover costs associated with ‘portfolio churning’ (unnecessary and excessive buying and selling to increase transaction charges).
- Tax: The way the fund and the investor are taxed is important because it will affect the ultimate return. Check for income and capital gains tax implications and consider how these might change over the investment period; for example if the individual retires and moves from a higher to a basic rate of taxation. As a general rule never invest purely for the sake of obtaining tax relief; investments must be appropriate for the individual’s circumstances and must be attractive with or without the tax breaks.
