Investment security in wealth management

What is security? To be able to define it, you must first answer the question of what threatens the wealth that we gather so hard. Our wealth has three basic enemies: 1. Destruction, e.g. during war; 2. Confiscation, e.g. by natio-nalization or overtaxation; 3. Loss of the real value, i.e. dangerous inflation. Fortunately, the two first enemies are quite rare. And that is good because there are very few measures we could take to protect against them. In other words: they are beyond our control in the field of managing this risk.

Inflation comes full circle

The enemy, which we face every day, is inflation, i.e. the loss of the real value of our funds. Thinking about it, we do not experience such extreme emotions as in the case of thoughts of war or confiscation. However, it is worth remembering that there were periods when inflation practically zeroed the accumulated funds, in particular the value of cash and bonds. High inflation does not only concern a handful of developing countries (hyperinflation in Zimbabwe), nor those struggling with post-war trauma (Germany, Japan) or the transformation shock (Poland). A very large number of countries, including the most developed ones (e.g. USA) experience periods of higher inflation from time to time. We can therefore assume that we will face it sooner or later – this is definitely a bad news.

How to manage wealth in times of inflation?

The good news is that this risk can be managed. Shares, especially the global portfolio, effectively protect against the risk of inflation in the long run (here webuy real business: machines, buildings, profits increasing with inflation) and offer a real rate of return well above secure deposits or treasury bonds. However, this protection is not free. There will be periods and even years when the fluctuations in the portfolio value will be significant. We pay more or less stress and nerves for the price of long-term, higher real rates of return. For those who are unable to accept this variability, there are inflationindexed government bonds. We must remember one thing: secure investments (deposits, treasury bonds) guarantee peace in the short term and should be part of the investor’s portfolio. Assets with much greater variability and/or low liquidity: stocks, real estate, stress and worry in the short term but can protect money against inflation in the long run and have a much higher expected long-term return.

How to make investment decisions?

So what should you pay attention to when making investment decisions? The first thing is to set the portfolio risk at the right level. The risk must be “calculated” so that the investment will not be closed at the time of the biggest drops. Market timing, or an attempt of the so-called “feeling” the market, consisting of high involvement in shares, when we expect increases in the market and low involvement, if we expect drops. In theory, this looks attractive, in practice it is one of the main factors of investors’ failure. Instead of adhering to the “buy cheap, sell expensive” principle, in practice it looks exactly the opposite – investments are bought after increases and sold after drops. A good practice of private banking is to build a liquidity buffer, created on a regular basis with a perspective of 1-2 years, consisting of deposits, treasury bills and safe short-term bond funds. The rest of the investments can be treated long-term. There is no need to withdraw funds in the least favorable time, i.e. in conditions of severe recession (when our business is doing worse) or when we lost our jobs.

Compare costs and rates of return

Costs are another important issue. For example, if you want to buy a bond fund where the portfolio profitability is slightly higher (or lower) than fees, you may want to consider another investment. At a time when the fund operating on equity markets shows high fees in relation to longterm rates of return on this class of assets (e.g. US shares or shares of large Polish companies), one should also consider looking for another alternative investment method. The third thing is to avoid “magical” products offering a high risk-free rate of return, indicating exceptional investment opportunities. These types of investments can end in a severe loss. The key to success in wealth management is to mix the elements of risk and security properly, avoid behavioral errors, and control costs. These are the things that we work on with our clients on a daily basis.

Author:
Jarosław Przybył, dyrektor ds. produktów inwestycyjnych Private Banking w Alior Banku

Last Updated on October 2, 2020 by itband