The word ‘balance’ is defined by Oxford Languages as “an even distribution of weight, enabling someone or something to remain upright and steady”. In mathematics ‘balanced’ is defined as “when both sides have the same quantity or mass”. Of course, you already know this.
Balanced: When both sides have the same quantity or mass
But balanced is also a term encountered regularly in finance. It’s used to describe the ‘medium’ risk investment portfolio.
So why then, do I encounter so many decidedly unbalanced, medium risk portfolios, and what do we at Bunker Riley advocate as ‘balanced’ for our clients?
Why is this important?
Risk is central to understanding an investment’s likely return experience. The size and frequency of both the ups and downs, as well as the long-term average return. Too high risk and you might get scared into making a bad decision when the portfolio declines more than expected during one of the many, normal, temporary declines. Too low risk and muted long-term returns might not allow you to reach your financial objectives.
Also, when comparing the performance of different ‘balanced’ investments, you really want to make sure you are comparing like for like and not just going by the name alone. I saw two advisers debating their firm’s medium risk one-year investment performance recently. One was 5% and the other 12%. Were they genuinely comparable? Very, very unlikely.
A disclaimer of sorts though. The definition of risk is complicated. It can be measured in different ways. Risk is different for different people, different objectives, and different situations. Risk is also a full-time profession for some people. I’m keeping it simple and short here for readers. If you happen to be a finance pro or academic with a 30-page paper, don’t come at me on technicalities. This piece isn’t written for you.
So, with that stated let’s take a brief look at what a balanced risk investment is.
What is a Balanced Risk Investment?
To understand this, you need to appreciate that stocks and shares, or in my day to day, equity funds, are “risk assets”. They have a significant degree of short-term price unpredictability and risk of loss but offer above inflation returns for those with patience.
Some Government Bonds on the other hand are considered to be a form of “risk-free asset” because a fixed return is offered and the full faith and credit of the UK government back it. However, the reality is that all savings and investments carry some degree of risk, even cash.
Holding a traditional mixture of risk and risk-free assets can help control the overall risk of loss, the potential long-term return, and your own mental stress of ownership. This is because stocks and bonds are a typical example of historically ‘uncorrelated’ assets. The idea is that when one part of the portfolio falls, hopefully, the other rises, or at least doesn’t fall to the same degree. Consider it leaving the house with both an umbrella and your sunglasses rather than one or the other.
Now, there are many investment sub-sectors, such as corporate bonds, high yield, large or small stocks and Alternative Investments like commodities, private equity and hedge funds which can either add to or hope to diffuse, a portfolio’s risk. This complicates the ability for most to make a risk assessment. To overcome this, many investors trust that by selecting an investment with ‘balanced’ in the description, they are getting what in my mind would be the rational definition of balanced. 50% stocks and 50% bonds.
What Balanced Often Looks Like
Why is it then, when we look at some popular investment portfolios, they look anything but balanced? As of 31st October…
Wealth manager Brewin Dolphin’s ‘Balanced Portfolio’ includes 77% in equities and Absolute Return (an alternative form of investment).
Fund manager Jupiter’s popular ‘Merlin Balanced Portfolio’ includes 69% in equities, which jumps to 83% if gold and commercial property is included.
National financial adviser firm St James Place ‘Balanced Portfolio’ includes 43% in equities bumping up to 66% when their 23% allocation to ‘alternatives’ is included.
The highest I ever saw was in the balanced portfolio of a client joining us from Canaccord Genuity Wealth Management with close to 85% equities!
There could of course be good reasons why each of the managers above is invested the way they are. A different aim, statistic, or definition of the term balanced could be used and the managers may have the authority to increase risk at times of ‘opportunity’. However, to the everyday investor, unless you understand why they are doing what they are doing, higher allocations to ‘risk assets’ looks decidedly unbalanced.
Do you need to be exactly 50/50 to be balanced? No. Assets change in value over time and a little drift one way or the other is perfectly acceptable and easily rectifiable with the occasional reset. Likewise, a little more emphasis could be intentionally placed on growth with a slightly higher allocation to equities, or caution with a little less. But that moves you away from balanced. What do we do at Bunker Riley?
Well, we want you to intuitively understand how much ‘risk’ you take within your portfolio. Most (but not all) risk of loss comes from investing in equities, so we use your allocation to equities as a barometer for investment risk. We risk rate our portfolios from 1 to 10, low risk to high, allocating more equities at each step up. If you’re a risk level 3 then we allocate 30% to equities, if you’re risk level 4 then it’s 40% and so on in steps of 10% until the highest risk level of 10 is 100% equities.
Each level has a name such as ‘Defensive’ or ‘Fearless’ but importantly the medium risk level of 5, our ‘Balanced’ portfolio, is allocated 50% to equity funds and 50% to bond funds. Makes sense, right?
So why do some firms call portfolio’s with as much as 80% in risk assets ‘balanced’?
I really don’t know, but I’d hazard a guess that it has to do with favourable performance comparisons and attracting investor assets.
We know that most investors declare themselves as balanced, rather than cautious or adventurous. And we know that investors mistakenly focus on past investment performance as a tool for choosing funds. We also know that more equities are likely to improve long term investment returns. So, if you compare the performance of a range of ‘balanced’ investment options over 5 years for example, but don’t look under the bonnet, you’re likely to choose the fund with the highest return, not considering the extra risk taken to achieve those returns.
It’s a big and lucrative slice of the market for portfolio managers.
Moral of the story. It’s complicated out there. If you don’t know how to evaluate your own investment proposition, talk to an independent, Chartered or Certified Financial Planner to steer you clear of surprises.
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