For professional investors such as pension funds, an idea known as “liability-driven investment” has been fashionable for some years now. It’s essentially a complicated way of expressing a very simple idea – that the investments you hold should reflect the reason you make them. So, for example, a retirement fund with large numbers of pensioners who must be paid pensions might choose to hold investments that will generate the income required to service these payments.
It’s really just common sense – if you’re investing for a particular reason, it’s logical to choose the assets you hold on the basis of whether they’re appropriate for this need. All of us should at least be applying the underlying principles of this approach to our own financial planning.
Focus on your goals
What that means in practice is that you need to choose savings and investments on the basis of the goals you hope to achieve – rather than, as is too often the case, on the basis of which market is expected to be hot over the next few months, or which fund manager seems best placed to post stellar returns.
That’s not to say there’s no room for investment decisions based on your views about markets, fund managers and other factors likely to have an impact on performance; but these should be secondary considerations.
Think of it in this way: your financial needs, the duration of your investments and your attitude to risk will provide you with a basic framework for your portfolio – how much you should hold in equities, say, versus fixed income securities or other types of asset. You can then start to fill in the framework by making choices about how you achieve this asset allocation.
In fact, while we all get hung up on whether one particular fund is doing better than another, the final choice of portfolio holdings is much less important than getting the asset allocation right. Academic research suggests that as much as 50 per cent of the performance of your portfolio will depend on asset allocation, a much more significant factor than individual security selection or market timing.
The right fund for the occasion
Moreover, what you’re looking for is performance that delivers your particular financial needs. If you require, say, a consistent income over the next five years in order to help meet school fees, there’s not much point in investing in a fund that pays no income and generates hugely volatile returns – even if that fund turns a huge profit in 10 years’ time.
Similarly, if you’re 35 now and putting money into funds that you plan to use to generate a retirement income in 30 years’ time, it’s seems daft to worry about, say, a six-month run of negative returns.
Successful investment, in other words, is not an absolute discipline – when you choose savings and investment products, you’re not looking for the largest possible profit, counter-intuitive though this might seem, but the perfect return profile for your individual needs. Just like the professional investors, you need assets that are well-matched to your liabilities.
Over time, of course, your needs may change, or you may find that your initial choices aren’t delivering what you hoped for. Keep your investments under review on that basis.
Theory into practice
How, then, to save and invest according to these ideas in practice. Well, the investment companies sector has much to offer, with a range of different funds offering very different profiles. The industry has a good story to tell on income, because investment companies are allowed to keep some dividends back in good years to pay out in leaner times. Its growth record is impressive too, outperforming, on average, comparable open-ended funds over longer periods.