How to minimise risk but maximise return

Investing is not gambling, not if you do it right. But if you are investing in an ISA, how do you minimise the risk without sacrificing too much return?

Article updated: 9 April 2018 12:00pm Author: Michael Baxter

I have been playing with Excel, experimenting with different but simple investment strategies. The best strategy that came out the other end, may surprise you.

Investing does not have to be risky, especially via an ISA

‘Oh, investing in stocks and shares, it’s a form of gambling isn’t it?’ I often hear that. Well, let’s set aside that the stock market exists as a way to encourage investment into companies, so that they can in turn help create wealth, so by investing in the stock market you are effectively doing your bit to support wealth creation. Let’s also set aside that this contrasts with investing in property.

But if you put your money in cash, in say a deposit account of the bank, then you are taking the risk that your wealth is eaten away by the ravages of inflation.

Whereas, if you follow some simple rules, the risk of investing in shares is whittled away. So, if you make sure your portfolio is:

  • Diversified
  • Non-correlated, meaning that not all the stocks in your portfolio are likely to rise and fall in synchronisation, so that means, for example, diversification among sectors as well as stocks
  • Also have a long-term investment horizon

then the risks can be reduced substantially.

If you are investing in the stock market with the view to withdraw your money next Tuesday, then that is high risk, and indeed a form of gambling. If you have say, a ten-year time horizon, then I would say the opposite.

Linked to that, sell shares because you feel such a sale makes good investment sense, never be in a position in which you sell because you need the money.

Another way to reduce risk, is to invest in an ISA.

Of course, it is common sense, you can invest up to £20,000 a year in an ISA,as can your partner, and there is no capital gains tax to pay. Aside from the money you save, it saves hassle too – lets’ face it, filling in tax returns is not fun, but when your income derives from an ISA portfolio, it becomes easy.

But there is one other idea, and it is this, which I want to take a deeper look at. And that involves drip-feeding your portfolio – what I call diversification over time.

So, instead of investing say a lump sum, you invest in monthly amounts?

Does such a strategy make sense?

My experiment

As my starting point, I assumed that the investor begins building an ISA portfolio at the beginning of the financial year. And just to take the worse possible scenario, I assumed that this investment begins in 2008 – the year of the financial crash.

2008 was an awful year to start investing. Indeed, for that matter, the last ten years have not been so good. As I write, the FTSE 100 is just 19 per cent up on the price at the start of the 2008 financial year.

If instead, you had begun investing at the beginning of the 2009 financial year, the FTSE has grown by around 45 per cent. But that is being wise in hindsight. I am interested in finding out what simple formulae you could have applied to minimise risk and maximise returns.

Bear in mind that this is not just about the performance of the index, but it is about dividends too.

The model

So, I am assuming that your portfolio tracks the FTSE 100, and enjoys dividends in line with the index, and you invest 100 per cent via an ISA, so, except for stamp duty, there are no tax payments.

On the 7th April 2008 the FTSE was at 5,947. At close of play on April 5th 2018, it was at 7,202.

Dividends from the FTSE 100 have varied, but I took the average dividend over this ten-year period, which was 3.7 per cent a year.

Scenarios

I took four scenarios:

In scenario 1, you invest £12,000 on the 7th April 2008. In scenario two, you invest £12,000 in 2008, but in 12 equal monthly payments. In scenario three you invest £12,000 at the beginning of each financial year, and in scenario four you invest £1,000 a month.

Which works best? Obviously, in scenarios three and four, your portfolio ends up worth more, as you have invested more.

But looking at percentage returns, I found that scenario two worked best, creating a return of 104 per cent. If instead you had invested the £12,000 upfront, total return would have been 78 per cent.

In scenarios three and four you get a return of 50 and 48 per cent respectively, suggesting that in the long term, you are better off investing a lump sum at the beginning of each year than investing in monthly instalments.

*The ISA limit in 2008-09 was £7200, therefore the above example value is for illustration purposes only

Conclusion

To reduce risk, to minimise the danger of a stock market crash occurring just after you start investing, you may be better off to drip feed your investment in year one. This won’t necessarily get you the better return, but it does limit the downside risk.

But from year two onwards, in the period I looked at, you would have been better off to pay as much in as you could at the beginning of each financial year.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.