You don’t have to be a professional fund manager to build your own portfolio. You just need to be clear about your goals, make sure your investments are aligned with those goals, keep your costs down and remain disciplined if markets turn against you in the short-term.

In this series we flesh out our four investment principles and break down the task of building a portfolio into seven bite-sized chunks.

Let’s start with the mental trade-offs that we all must make, to some degree, in life. Such dilemmas as, for example: ‘if I wait longer to settle down it could boost my career but it might also make it harder to find love and start a family’, or, ‘if I extend my studies it could help me get a better-paid job in the future but there’s no guarantee of this and it’ll also cost me time and money in the meantime’.

Weighing up the potential rewards against the possible dangers is hard-wired into all of us. It’s something that has enabled humanity to thrive.

When it comes to investing it is also encapsulated in the concepts of risk and return. These are central to the task because when you invest you are taking some sort of risk in the hope of generating a return.

Value of your investments can go up and down

When you invest, you’re buying something. It might be shares in companies or bonds issued by a government. Whatever it is, the prices of the things you buy (let’s call them assets) will rise and fall from one day to the next – and, in most cases, they will move around during the day as well.

You are buying those assets in the hope that their prices, and hence the value of your investment, will go up over the long term. But there’s no guarantee because prices can also fall and sometimes these falls can be significant. This means that when it comes to selling your investment, it might be worth less than when you started.

Why take the risk?

You may well now be thinking, why run the risk of losing money when I could just leave it in the bank?

The answer is that the risk to your capital is balanced by the potential for higher returns. Investments whose prices move around a lot – such as shares – have tended to produce better long-term returns than those whose prices are less jittery, like bonds.

The performance of different investments from 2001-2021

Past performance is not a reliable indicator of future results. 
Sources: Bloomberg, as at 31 December 2021. Indices used: Bonds: Bloomberg Global Aggregate Total Return, hedged in pounds sterling. Equities: FTSE All-World Total Return, in pounds sterling.

And although bonds are less volatile than shares, their prices do still move, so they carry more capital risk than leaving your money in the bank. Reflecting this hierarchy of risk, bonds typically provide long-term returns that are higher than cash but lower than shares.

Why does this matter?

This matters because whether you’re saving in the bank or investing in the markets, you want your money to grow at a pace that at least matches inflation – in other words, you want £100 today to be able to buy you at least £100’s worth of goods in the future.

If you leave all of your money in the bank, you run the risk of your money failing to keep up with inflation, leaving you poorer in real terms in the future.

Know what’s right for you

So, there’s a general relationship between risk and reward: if you’re comfortable taking more risk, you can reasonably expect to receive higher returns over the long term.

And, conversely, if you don’t want to take so much risk, you will need to accept the likelihood of lower long-term returns. If something sounds too good to be true – for example, an investment that promises high returns with little or no risk – then you should be wary.

That raises the question: what balance of risk and return is right for you? Are you aiming for the stars and prepared to ride out the bumps in the road along the way? Or are you wary of losing money and prepared to accept lower returns?

It’s a tricky one to judge, which is why at Vanguard Personal Financial Planning we use risk-profiling technology to guide the decision.

Only you can truly know the answer. But to help you find your sweet spot on the risk-reward spectrum, it helps to start with your goals. Are you investing for something a long way into the future? Or will you need the money at a set date in the next few years? Does your goal have a specific price tag?

Our goals guide will help you think about why you are investing. The next article in this series looks at shares versus bonds – both what they are and what they can offer investor.