FOOL'S EYE VIEW
How To Spread Your Risk

By James Carlisle
March 11, 2002

Carburton Street, London -- A fundamental concept in investment is that you need to 'match your assets with your liabilities'. The idea is that you should have investments that will produce what you need, when you need it. This is a straightforward matter when you're dealing with short-term liabilities. For example, if you have a bill to pay next week of £100, then you'd want to have £100 in your bank account to pay it at that point - either because it's already there or because you get paid between now and then.

For long-term liabilities, like your spending money in retirement, accumulating a pile of cash doesn't work very well. The problem is that we just don't know what our cash is going to be worth in tens of years' time. To put it another way, if we're talking about, say, 30 years' time, then what you need is not one pound, but the equivalent spending power of a pound today (or hopefully a bit more!).

The Pitiful Pengo

Cash has shown itself to be pretty bad at holding its spending power over the years. The worst example in modern times was in Hungary where, by 1946 you'd have needed 130 million trillion 'pengos' to match the spending power of just one pengo 15 years earlier. World War II didn't help, but if you're investing for long periods, you have to be prepared for that sort of thing.

In Hungary, you'd have been better off owning a 'real' asset like property or shares. After all, if your property could generate weekly rent of 1 pengo in 1931, then it would probably have been able to generate 130 million trillion pengos in 1946. Businesses do a similar thing. A Hungarian grocery shop would, all things being equal, have been able to make profits (and pay dividends) of 130 million trillion times as much in 1946 as it could in 1931, because the prices of the goods that it sells to make a margin would have increased by that amount.

Matching Your Assets To Your Future Needs

So, if we're trying to preserve our wealth to finance our retirement in decades to come, then things like houses and grocery shops are likely to be more reliable than cash. We can take things further than this, though. If we expect to be living in the UK when our retirement comes along, then what we want is money that can be used to buy our groceries here. That means that a grocery shop in Hungary wouldn't do us much good, since we won't be needing to buy food in Hungary and the prices could be wildly different.

If we want to be confident of being able to afford groceries in this country, then we'd be wanting shares in Tesco (LSE: TSCO) or Sainsbury (LSE: SBRY) or, perhaps, if we live in the North, Morrisons (LSE: MRW). It might also be an idea to own a part of the businesses that make the groceries - like Associated British Foods (LSE: ABF) or Unilever (LSE: ULVR). If you like a drink, then it might be sensible to own a slice of Diageo (LSE: DGE). Without putting too fine a point on it, it might be an idea to tuck away a pharmaceuticals company like GlaxoSmithKline (LSE: GSK) or AstraZeneca (LSE: AZN) for when you're old and creaky.

Not all areas of your expenditure will involve British companies. Cars, for example, are dominated by manufacturers in the US, continental Europe and the Far East. Mobile phones come from Scandinavia, the US and Asia, although a UK company, ARM Holdings (LSE: ARM), does lead the market on the processors used inside most of them and Vodafone (LSE: VOD) is the world's largest mobile network operator.

So, to gain a perfect spread of risk for the long-term, you'd need to invest in companies in proportion to their contribution to the things that you expect to spend money on. That's a little tricky, since we don't really have much of an idea what we're going to want to spend money on, let alone which companies will actually be producing it.

The best we can do is to invest in a spread of companies that's representative of what might be going on in the future. For people expecting to retire in the UK, that probably means having the bulk of your savings spread across the UK stock market, with smaller amounts invested in the US, Europe and, possibly, the Far East.

How do you manage that?

There are several ways of achieving this, depending on how broad a spread of shares you want and how much time you want to put into it.

The tracker approach

The simplest thing would be to invest in index trackers that follow the various market indices of the regions around the world. For the UK, the most appropriate index to follow is probably the FTSE All Share, while in the US, it's probably the S&P 500.

For Europe, there's a range of different index trackers following different indices. When selecting one, it's important to keep in mind what you're trying to achieve: a spread of shares that reflects, and will continue to reflect, the growth in the European economy. That means you'll want a weighed index and you may want one that excludes the UK (if you've already got enough UK exposure through a UK tracker).

The Far East is more difficult, since there aren't really any indices or trackers that fully reflect the area. One approach would be to take the view that your other (European and American) investments sell enough of their products to the region that you have enough exposure to it. You could then just ignore it. Another would be to go for individual country trackers, but that will start to get very fiddly. The other option would be to go for an actively-managed fund or direct shares.

There's more about how index trackers work and how to choose them in the Motley Fool's ISA centre.

The investment trust approach

The largest investment trusts tend to have very low charges and can therefore make efficient investments. The handy part of it is that the largest UK investment trusts are mostly in the Global Growth sector which, as the name suggests, gives you an international spread of investments at one fell swoop.

Before investing in these, however, it's worth checking the geographical spread, so you know what you're getting into. You can do this with the Association of Investment Trust Companies 'Monthly Information Service', which is on its website. There are four investment trusts in this sector that have over £1 billion in total assets and I've listed them below, together with their current spread of investments.

Investment     --------------Equities (%)--------------   Cash &
Trust          UK  Cont.  North   Japan   Other   Other    Fixed
                  Europe  Amer.         Pacific         Interest

Foreign &      36     23     25       7       4       3        2
  Colonial

Witan          57     9      22       4       5       0        3

Scottish       45    13      24       5       4       2        7
  Mortgage

Scottish       45    11      29       3       4       0        8
  Investment
  Trust

For UK investors, depending on the balance you want, and there aren't really any right or wrong answers, all of these will give a good geographical spread. Of course, if you spread your money between all four of them, you'd have a very broad spread indeed.

The direct shares approach

The direct shares approach, as the name suggests, involves buying direct shareholdings. Very few people, however, will have the time or inclination to research companies from all over the world, so this is only likely to be a partial solution.

The combined approach

Most people will find that a combination of the above approaches will work best. For example, you might choose to hand pick your shares in the UK, while also investing in US and European index trackers and an Asian investment trust. Alternatively, you might choose to have most of your money in a spread of the Global Growth investment trusts, with some direct UK shares on top, selected according to your preferred strategy.

More: The Motley Fool ISA Centre