Portfolio construction: Defining your cautious approach

This week we focus on the first step towards setting up a cautious portfolio; if you are an IFA, understanding what cautious means to your client, or if you are a private investor what it means to you.

The first major hurdle when it comes to building a cautious portfolio is reaching an agreement between client and adviser on what cautious means, according to Ben Yearsley, senior investment adviser at Hargreaves Lansdown.

"The danger is that low risk is often associated with no risk," he explained. "It’s fine if the market goes up 20 per cent and your client’s portfolio only goes up 10 per cent, but if the market drops 20 per cent and your client’s portfolio drops 10 per cent that’s when they start to get upset."

"They don’t see how that can be 'cautious'."

Philippa Gee, managing director at Philippa Gee Wealth Management, agrees. "I’ve had people come to me saying they are cautious when really they want cash, they don’t want any risk at all," she said.

"By the same rule, I’ve had others come to me saying the same thing – but they’re basing that on a comparison with an aggressive strategy so their perception of what it means is very different."

Rob Gleeson, investment product consultant at FE, thinks there is a rift between what professional investors see as cautious and what private investors think about the same thing. "Cautious has an unhelpful dual meaning when it comes to portfolios, it is used to describe investment risk and also a risk appetite in the investor," he explained.

"These two things are not the same. The industry convention of using volatility as a catch-all measure of risk is probably one of the biggest things hampering retail investors. Volatility only measures the range of expected returns, whereas most people think of risk in terms of losing money."

Yearsley thinks investors need to understand that a cautious investment still engenders risk, because it involves exposure to equities. "In my view a cautious investor is someone who is prepared to invest in equities and accept market volatility to a certain degree," he continued.

"These are people who want to outperform cash but don’t want full-on high-risk stuff. The important thing to remember though is that they do want some equity performance.”

Gleeson added: "The most accurate description of a cautious investor is one who won’t be tempted to chase higher returns if it means an increased chance of not meeting their investment goal."

Yearsley thinks examining previous negative periods is a useful, simple mechanism to establish an investor’s true risk tolerance.

"It’s difficult to classify investors because attitudes to risk are different among different people. One way to get around this is to look back at the history of a fund and consider its maximum monthly losses and gains."

"If you examine these losses and ask yourself whether you’d be willing to accept this level of volatility, that’s a good guide towards your attitude. You need to put a fund into context, asking your client whether, if the fund fell, say, twenty per cent in a month, they’d be comfortable with it."

Gee says establishing an agreement on what cautious means at the outset is essential for the adviser and the client. Without this concord, the former may face claims of mis-selling or at the very least a disgruntled customer, and the latter may feel they’ve been bamboozled into a fund they didn’t want.

"This agreement on what cautious means is the defining moment in the client/adviser relationship in this context. If you as a private investor accept the classification of risk that your adviser has put you into, everything that follows is based upon that, so if there are any alarm bells ringing at all you need to say something."

Gee says it is important to consider the classification carefully and not rush the decision.

"Spend a bit of time reading it. Look at the wording of the approach which your adviser is recommending to you. You need to really look at this, because if you’re an investor with an existing portfolio what you really do not want is the adviser to steer you into a risk profile which allows them to change everything, not for your benefit but for theirs, because of the commissions involved."

Next week, FE Trustnet will examine the top-down asset-allocation strategy required to begin developing a cautious portfolio. Click here to sign up for FE Trustnet emails and we’ll send the article directly to your inbox as soon as we publish it.

To propose a question about cautious investment strategies click here.