Alice Guy explores whether to take more investing risk in the year ahead and the sectors she's considering in 2023.
As the new year dawns, our attention turns to what we’d like to improve this year.
For me, personal goals include rekindling my love of cooking with a bigger range of family recipes – OK admit it, I’m stuck in a rut!
Each January I take a look at my pension and check if I’m still on track with my plans. How has my pension performed this year, and do I need to adjust my contributions, asset allocation or fund choices? This year I’m wondering whether to take more risk or stick with my existing portfolio.
Reviewing pension goals and contributions
Sitting down and taking stock reveals that I’ve got some serious investing to do if I want to build a decent-sized pension pot. Fortunately, after a long career break in my 30s, I’ve still got time on my side to boost my lagging pension pot before retirement.
I want to aim for a pension pot of around £470,000 to hopefully achieve a pension income of around £17,000. Using an interest compound calculator, I can now work out how much I need to invest each month to achieve this goal.
I’ll need to make assumptions about the level of investment growth. I usually assume 3% as this takes inflation into account – 5% minus 2% inflation. Knocking off 2% inflation is a nifty short-cut as it allows me to estimate the current value of any future pension pot.
In reality, using an interest compound calculator is only a ballpark figure. There are too many variables to be able to give any degree of certainty about the future value of my pension. The level of investment return and inflation will make a huge difference to the value and spending power of my pension pot by the time I retire.
For example, investing £500 for 40 years with a net investment return of 3% (5% minus 2% inflation) would produce a pension pot worth £463,029. But if investment returns rose to 4%, that pension pot available at retirement would increase to £590,980, while a reduced return of 2% would produce a pot worth a much lower £367,217.
Can I beat the system?
One way to secure a potentially greater return is to go for higher-risk sectors which have outperformed in the past. But the problem with this strategy is that it’s potentially a gamble as those sectors also tend to be more volatile.
Unlike those bullish YouTube videos, there’s no short cut to investing success: a magic fund where you can guarantee 7% or 8% returns.
But there are sectors that have produced higher returns in the past and may do so in the future.
To balance out this risk and reward, some experts suggest splitting your investment portfolio 70/30% between less risky and more risky investment choices. The 70% portion might include tracker funds, defensive sectors, bonds or cash, whereas the more risky 30% allocation might include smaller companies, emerging markets or even alternative assets.
Of course, this 70/30% split isn’t suitable for everyone and the right asset allocation for you will depend on your attitude to risk, financial circumstances and the time horizon of your investment.
Sticking with the status quo?
For me, this year I’m revisiting my long-used pension strategy to see if I still want to invest 30% of my pension in more risky sectors in the hope of securing higher returns in the future. Or instead, should I increase or reduce the risk in my portfolio?
I’m in two minds: it’s looking increasingly likely that we’re in for further stock market turbulence this year. In one way, with around 20 years till I retire, I’m tempted to use the opportunity to buy cheap and invest in more risky growth stocks.
On the other hand, I’m a big believer in sticking with your long-term investing strategy and not being swayed by emotion.
Topping up my smaller companies exposure?
If I do decide to increase my investment risk, one area I’m considering is smaller companies. Smaller companies have the advantage that they tend to outperform larger companies in the long run as they have more potential for growth. The FTSE Small Cap index returned 180% over the past 15 years, compared to 104% for the FTSE 100. Likewise, the MSCI World Small Cap index returned an amazing 312% over the past 15 years, compared to 266% for the MSCI World Large Cap index.
On the flip side, smaller companies are much more volatile than larger companies, meaning larger caps often win out over a shorter time frame. The MSCI World Small Cap index returned 20.1% over the last three years, compared to 28.5% for the MSCI World Large Cap index.
Although interestingly, in the UK, the FTSE Small Cap Index beat the FTSE 100 over three, five, 10 and 15 years, while lagging over the past year.
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But it’s not just volatility that makes smaller company funds more risky. As the Neil Woodford debacle reveals, a lack of liquidity can be a big risk when it comes to smaller company funds.
The ill-fated fund went into a doom spiral as investors rushed to sell their holdings after bad publicity. Woodford struggled to sell the fund’s shares quickly enough to pay them back. This led to the fund being suspended and then collapsing and being shut down.
It’s a salutary reminder of the potential liquidity risk for smaller company funds as their shares generally take longer to sell than larger companies. Most smaller company funds would take around nine days to sell 20% of their holdings, compared with one day for larger company funds. And some smaller companies funds could take more than a month to sell 20% of their portfolio.
Adding more spice?
With this in mind, another option, rather than changing my 70/30% asset allocation, is to add more spice or diversify within the more risky 30% part of my portfolio.
In the past, I’ve invested in a mix of smaller company open-ended funds, but not specifically in any unlisted shares. Unlisted shares are obviously even more risky than smaller companies funds as it’s harder to value and sell them. But there’s also potential for more growth as fledgling companies are earlier in their growth cycle.
I’m therefore weighing up adding a private equity fund to the mix, although I won’t invest more than 5% in something so potentially risky.
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Investments trusts have the advantage that a doom-spiral is less likely than with open-ended funds. That’s because they’re able to trade at a significant discount, rather than suspending trading if they face significant outflows.
They’re also arguably a more suitable vehicle for smaller company shares. They can reflect the hard-to-value nature of smaller companies by trading at a discount where the future economy and, therefore share values, are uncertain.
On the other hand, investment trusts are potentially more risky and volatile than open-ended funds. They have the ability to borrow to fund purchases, which means they can grow more or sink further if they make the right or wrong decisions.
Several established investment trusts are currently trading on an attractive discount, so there’s a potential for outperformance in the future if those discounts reduce.
So, as the quiet of Christmas gives way to the busyness of January, am I going to take more risk this year with my pension? Well yes, and no.
For me, the 70/30% split between tracker funds and more risky assets has worked well over the years and I’ll probably stick with it.
But I’m seriously considering buckling up and taking a little more risk with the 30% part of my portfolio. I’d like to add a couple of smaller companies investment trusts, a private equity investment trust and possibly another emerging markets trust to the mix.
Let’s hope for a prosperous 2023 and that my decision to take just a little bit more risk pays off in the long run!
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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