When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Investment returns: balancing risk & reward
Balancing investment return and risk is to consider both how much an investment could make and how much it could lose. This relationship is called the risk-reward ratio. Keeping this ratio steady helps stabilize your average portfolio return over time.
What is investment income if not steady growth regardless of the market’s whims?
What is investment income if not steady growth regardless of the market’s whims?
QUOTE
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
There are numerous investment income strategies out there. Something all the successful methods have in common is that they’re designed to work over the long term…and not only when everything is ‘coming up roses’ anyway!
Big ideas
- Chasing after a spectacular portfolio return isn’t always the best idea. It’s usually more rational to settle for consistent, reasonable returns.
- Classic investment principles like diversification and patience will always bear fruit.
- Sticking to these tried-and-true methods doesn’t mean that you shouldn’t keep an eye out for opportunities, though. Investing abroad, making small speculative plays, and finding ways to reduce your tax burden can all increase your returns.
What are good investment returns in today’s market?
The best investment returns U.K. funds can boast are just about in the double digits year on year, averaged over a reasonable period. However, a figure representing a percentage return does not tell the whole story. Any portfolio managed aggressively is bound to experience more volatility; it may also lose double digits in any given year (or even a single month).
Most investors can’t accept high levels of risk, not only on a cardiologist’s advice but also for reasons of good money management! There is, for instance, always the chance that you will need to cash out your portfolio in a hurry. This may be due to an emergency or a sudden opportunity; either way, getting out less than you put in will leave a sour taste in your mouth.
Most investors can’t accept high levels of risk, not only on a cardiologist’s advice but also for reasons of good money management! There is, for instance, always the chance that you will need to cash out your portfolio in a hurry. This may be due to an emergency or a sudden opportunity; either way, getting out less than you put in will leave a sour taste in your mouth.
In general, returns of between 5% and 8% are perfectly acceptable if you’re in the game for investment with returns that are, if not guaranteed, at least anticipated. An investment with high returns (potentially) will never be something you’d want to bet the farm on!
Note that this doesn’t mean that you have to shun high-risk/high-reward opportunities completely. Assuming that your investments are prudently diversified, what matters at the end of the day is your portfolio investment income, not whether any particular stock shines or shrinks.
Note that this doesn’t mean that you have to shun high-risk/high-reward opportunities completely. Assuming that your investments are prudently diversified, what matters at the end of the day is your portfolio investment income, not whether any particular stock shines or shrinks.
DEFINITION
Portfolio income is the total gain or loss realised by the mixture of investment assets you own.
Calculating returns for an entire portfolio can be done using this formula:
Portfolio Income = ∑ (Weight x Return)
where the “weight” of each investment is the proportion of money invested in it at the beginning of the period.
Calculating returns for an entire portfolio can be done using this formula:
Portfolio Income = ∑ (Weight x Return)
where the “weight” of each investment is the proportion of money invested in it at the beginning of the period.
Let’s return to the original question: what are good investment returns? The main takeaway here is that “good” returns are not necessarily defined by a number. Relatively modest gains can also be called good as long as they’re in line with overall market performance and weren’t achieved by assuming unnecessary risks.
Now that we’ve gotten that fundamental point out of the way let’s look at a few basic, practical strategies for achieving good investment returns:
Now that we’ve gotten that fundamental point out of the way let’s look at a few basic, practical strategies for achieving good investment returns:
How can diversification help achieve good returns?
Any investment that doesn’t require further involvement from you can be called a portfolio investment. For example, buying a small business is not a portfolio investment because it requires you to manage the business or at least hire managers to do so.
Portfolio investments, by definition, are part of a group of investments known as a portfolio. The ideal portfolio should be diversified, meaning that it includes unrelated investments. The reason for this is that while one particular investment may drop sharply in value due to unforeseen events, various unrelated investments will rarely do so.
To illustrate how this works, let’s take a look at the following (entirely hypothetical) portfolio investment example:
Portfolio investments, by definition, are part of a group of investments known as a portfolio. The ideal portfolio should be diversified, meaning that it includes unrelated investments. The reason for this is that while one particular investment may drop sharply in value due to unforeseen events, various unrelated investments will rarely do so.
To illustrate how this works, let’s take a look at the following (entirely hypothetical) portfolio investment example:
Asset Type | Portfolio Weight |
Bonds (U.K) | 25% |
Bonds (Offshore) | 25% |
Stocks (Oil and Gas) | 35% |
Stocks (Renewable Energy) | 15% |
A little thought will show how this kind of asset distribution strikes a balance between investment return and risk. If the British pound should fall against other currencies, the investment income U.K. bonds yield will be relatively poor. This will be made up for by the increased value of foreign bonds (and vice versa if the pound should rise). Similarly, if petroleum companies should take a hit, renewable energy stocks will pick up the slack, or the other way around.
This is also an example of hedging. Taking apparently contradictory positions in the market is often the wise thing to do. One kind of asset can be expected to do well if the other one falls in value. When you’re hedged, you can look forward to investment returns if things go the way you expect. If you guessed wrong, you may not see the growth you’d hoped for, but nor will you lose your shirt.
This is also an example of hedging. Taking apparently contradictory positions in the market is often the wise thing to do. One kind of asset can be expected to do well if the other one falls in value. When you’re hedged, you can look forward to investment returns if things go the way you expect. If you guessed wrong, you may not see the growth you’d hoped for, but nor will you lose your shirt.
Barbell strategy: Portfolio investment with a little excitement
Something you may also have noticed in our portfolio investment example above is that risky but potentially lucrative investments happen to be paired with stable but less profitable ones. The share prices of both petroleum and alternative energy companies can rise and fall. In general, though, oil and gas giants take a long time to change in value, while renewable energy startups may double or halve their worth virtually overnight.
You can’t predict (with any certainty) which way either will go, but you can be reasonably sure that the inertia of one will balance out the variability of the other.
You can’t predict (with any certainty) which way either will go, but you can be reasonably sure that the inertia of one will balance out the variability of the other.
Institutional investors like hedge funds can afford to take on many risky investments: as long as one out of ten turns out to be a “unicorn”, their portfolio return will still be adequate. Private individuals traditionally steer clear of risky propositions such as startup IPOs. With the barbell strategy, however, they can still reap the potentially enormous return for investment these offer without unbalancing their entire portfolio.
By the way, the “Barbell Strategy” was popularized by Nassim Taleb; he was a skilled market analyst long before he became a best-selling author. All of his books are worth reading if you’re an aspiring investor. His works don’t answer basic questions like “what is portfolio income?”, but his semi-philosophical musings on risk and uncertainty should be required reading in any MBA course.
By the way, the “Barbell Strategy” was popularized by Nassim Taleb; he was a skilled market analyst long before he became a best-selling author. All of his books are worth reading if you’re an aspiring investor. His works don’t answer basic questions like “what is portfolio income?”, but his semi-philosophical musings on risk and uncertainty should be required reading in any MBA course.
Example of calculating portfolio returns of a barbell strategy
Here’s what the results of such a strategy may look like using fictitious returns data and the investment returns formula given above:
Risky Assets Weight | % Return | Stable Assets Weight | % Return | Total Portfolio Return |
5% | 40% | 95% | 4% | 5.80% |
15% | -87% | 85% | 3% | -9.65% |
10% | 90% | 90% | -5% | 11.70% |
20% | 147% | 80% | 1% | 25.40% |
QUOTE
“Given a 10% chance of a 100 times payoff, you should take that bet every time.”
Buy and hold: portfolio returns come to those who wait
Investment income, by definition, involves a time factor. It’s not simply a question of your portfolio growing, but how long it takes to do so. This isn’t just a matter of mathematical tradition, though, but the key to an important insight into how the stock market works. Let’s take a look at the graph below:
FTSE 100 chart
Source: TradingView. Past performance doesn’t guarantee future results.This graph represents the performance of the FTSE 100 (the 100 largest companies on the LSE) over time. There’s no magical calculator for what investment returns you can expect from them next week, next month, or even next year. Over time, though, we can be pretty certain that the general trend will be upwards.
Some of the most successful investors rely less on fancy computer algorithms than on this bit of common sense. Assuming that there isn’t something seriously wrong with the company or industry you’ve invested in and no major natural disaster or war breaks out, the only thing you have to do is wait.
With this style of investment, high returns in the short term are not a priority. Assuming that you did your homework to begin with, though, you are well set up for investment income, dividends, and capital gains in the long run.
There is one caveat to this, though: your portfolio must be diversified, or it may suffer a blow from which it won’t recover. This means distributing investments among different economic sectors, geographical areas, and asset classes. The basic idea here is not that casting a wider net will necessarily catch more fish but that a small tear in your net won’t matter so much.
Some of the most successful investors rely less on fancy computer algorithms than on this bit of common sense. Assuming that there isn’t something seriously wrong with the company or industry you’ve invested in and no major natural disaster or war breaks out, the only thing you have to do is wait.
With this style of investment, high returns in the short term are not a priority. Assuming that you did your homework to begin with, though, you are well set up for investment income, dividends, and capital gains in the long run.
There is one caveat to this, though: your portfolio must be diversified, or it may suffer a blow from which it won’t recover. This means distributing investments among different economic sectors, geographical areas, and asset classes. The basic idea here is not that casting a wider net will necessarily catch more fish but that a small tear in your net won’t matter so much.
Recognising investments with high returns
The chart of the FTSE 100’s growth tells a pretty clear story. When talking about any individual stock, however, its investment return rate is far from certain. Here we can see the performance of several random companies (not from the FTSE 100), using their share prices on the 1st of May 2019 as a baseline:
Source: The Financial Times. Past performance doesn’t guarantee future results.In general, investing a significant amount of money into a single company is not a good idea. Even professionals with years of experience and massive resources get it wrong almost as often as they get it right. If your investment advisor is confident enough to recommend a particular stock to you, they are bound to have good reason; but diversification remains the best policy.
There are a few exceptions to this rule, though:
There are a few exceptions to this rule, though:
👉 The one-eyed man in the land of the blind
Suppose you have years of experience in a certain industry; it doesn't matter which. One morning, you spot an article in the newspaper about a certain new technology you wish you'd had back in your day. It's instantly clear to you that a particular company is going to have a significant edge over its competitors in future, so you buy some stock. The information you just saw is available to everyone; you just have the necessary insight and knowledge needed to interpret it correctly.
It could well be a good idea to take your findings to your advisor for advice before you act, though. There’s no real substitute for financial insight, experience, and common sense, especially when you’re about to make a decision in the heat of the moment. The chances are good, for instance, that the shift in value you anticipate has already been “priced in” by the market. This would mean that the opportunity to make a quick buck has already come and gone by the time you become aware of it.
It could well be a good idea to take your findings to your advisor for advice before you act, though. There’s no real substitute for financial insight, experience, and common sense, especially when you’re about to make a decision in the heat of the moment. The chances are good, for instance, that the shift in value you anticipate has already been “priced in” by the market. This would mean that the opportunity to make a quick buck has already come and gone by the time you become aware of it.
👉 Fringe alternative investments
There’s no law that says that all your investments have to be listed on a stock exchange. If you have a particular interest in fine wines, antique furniture, or koi fish, you can also put some of your money into buying these in the hope that they will appreciate in value.
These kinds of investments are even riskier than more typical alternative investments like hedge funds or derivatives. If you do really know your stuff, however, you can indeed limit or at least quantify your exposure.
These kinds of investments are even riskier than more typical alternative investments like hedge funds or derivatives. If you do really know your stuff, however, you can indeed limit or at least quantify your exposure.
👉 Investing in smaller businesses
You can also look up local, independently owned companies on the internet. Many of these have a page called "Investor Relations" or something similar on their websites. If you have faith in the company – not because the owner is your spouse’s cousin’s girlfriend’s neighbour, but for some tangible reason – you may be able to buy a stake in it.
Others offer bonds: basically a loan from members of the public to a company, but with very clearly defined terms and protections. Note, however, that while it's entirely possible to buy shares in companies that aren't listed on any stock exchange, this does come with certain risks. The London Stock Exchange (LSE), for instance, has very strict rules on what kinds of information a listed company has to make public. These financial reports are studied closely by numerous brokers and investors. This fact gives you greater peace of mind than a private company may be able to provide its investors.
Others offer bonds: basically a loan from members of the public to a company, but with very clearly defined terms and protections. Note, however, that while it's entirely possible to buy shares in companies that aren't listed on any stock exchange, this does come with certain risks. The London Stock Exchange (LSE), for instance, has very strict rules on what kinds of information a listed company has to make public. These financial reports are studied closely by numerous brokers and investors. This fact gives you greater peace of mind than a private company may be able to provide its investors.
Investment income vs capital gains tax: learn about tax-efficient investing
Let’s face it: nobody actually likes to pay tax. We enjoy having roads without potholes and police that come when you call them, so we understand the need to fund these services. Paying more than your fair share is both thankless and unnecessary, though.
Tax treatment depends on the individual circumstances of each client and may be subject to change in future.
Tax treatment depends on the individual circumstances of each client and may be subject to change in future.
How taxation on investment income works
When it comes to income from investments, tax comes in two basic forms: income and capital gains. You are most likely already familiar with income tax: this has to be paid as long as you earn more than about £12,500 per year (as of March 2023), whether from employment, business profits as a sole proprietor, or dividend payments. Income, meaning the total amount from all sources, of over £50,000 and £150,000 (as of March 2023) is taxed at progressively higher rates. There’s no separate investment income tax rate distinct from what you pay on other kinds of income.
In practical terms, there’s not much you can or should do to decrease your income from dividends. You can still make use of certain allowances to reduce the tax burden on these, though. How much dividend income is tax free? For the 2023 tax year, the first £2,000 is not taxable. Dividends from shares held in an ISA (Individual Savings Account) are also tax-free, provided that you don’t invest more than £20,000 in this product during any given tax year.
In practical terms, there’s not much you can or should do to decrease your income from dividends. You can still make use of certain allowances to reduce the tax burden on these, though. How much dividend income is tax free? For the 2023 tax year, the first £2,000 is not taxable. Dividends from shares held in an ISA (Individual Savings Account) are also tax-free, provided that you don’t invest more than £20,000 in this product during any given tax year.
Oh no! I’ve made a profit!
The rules on capital gains tax are slightly more complicated, but also offer several opportunities for savvy investors to increase their effective investment returns. Basically, whenever an asset you own – a stock, a second home, or in fact a stamp collection worth more than £6,000 – increases in value, you have to pay tax on the difference. In the U.K., the applicable rate can vary between 10% and 28%.
The good news is that capital gains of less than £12,300 per year are not taxable. Losses from underperforming assets can be used to lower your total liability, carried over into future years, or even set against income. Capital gains from investment ISAs within your allowance are also tax-free.
It’s also important to realize that capital gains tax only comes into play once an asset is realised, i.e. when it’s sold for a profit. The paper value of your investments doesn’t matter in this regard. This may, for instance, cause you to hold on to some investment until the next tax year. The specifics of capital gains tax, like when a share is deemed to have been purchased, are pretty intricate – if large sums are involved, you should definitely consult an accountant or certified financial planner before making any major decisions.
*Figures applicable as of March 2023
The good news is that capital gains of less than £12,300 per year are not taxable. Losses from underperforming assets can be used to lower your total liability, carried over into future years, or even set against income. Capital gains from investment ISAs within your allowance are also tax-free.
It’s also important to realize that capital gains tax only comes into play once an asset is realised, i.e. when it’s sold for a profit. The paper value of your investments doesn’t matter in this regard. This may, for instance, cause you to hold on to some investment until the next tax year. The specifics of capital gains tax, like when a share is deemed to have been purchased, are pretty intricate – if large sums are involved, you should definitely consult an accountant or certified financial planner before making any major decisions.
*Figures applicable as of March 2023
Recap
There are certain strategies you can use to improve your investment returns. You should steer clear of get-rich-quick schemes or secret, magical “systems”, though: chances are that they don’t work as advertised except under very specific market conditions. Diversifying your portfolio and investing for the long term remains the very best advice.
FAQ
Q: Why should I settle for single-digit investment returns?
Online sales pitches don’t tell you how easily ’high return’ investments can fall in value. For every double-digit gain, there is a double-digit loss. Somebody has to lose for someone else to win. Given that you’ll be competing with investors with great skill, it is almost inevitable that you’ll be on the losing side sometimes. Sticking with a diversified portfolio of stocks, bonds, and other traditional investments is far safer in the long run.
Q: Do I have to pay tax on dividends?
The rules on how dividend income is taxed vary from country to country. In the U.K., each person gets a personal allowance (currently £12,570) on which they do not have to pay income tax. If you’re retired, your total investment income may well fall below that level. In addition, each person receives a dividend allowance (currently £2,000) which is not taxable. Any dividend payments above that level are taxed as ordinary income.
Q: What is portfolio investment and why is it recommended?
The main idea behind a portfolio is collecting passive investment returns, meaning that you don’t have to play an active role in the business in which you’re investing. It also strongly implies a balanced allocation of different assets. While the future value of any one asset is hard to predict, mixing them together reduces your risk and greatly increases the chances of earning attractive returns in the longer term.
Q: Is it possible to invest without paying any tax?
Many countries have structures that encourage investment by allowing investors to avoid or at least defer tax on their earnings. In the United Kingdom, the simplest route is to open a stocks-and-shares ISA (Individual Savings Account). These offer performance comparable to that of mutual funds, but both dividends and increases in share prices can be enjoyed tax-free.
Q: I don’t want to miss the latest investment trends. What should I do?
You should never invest in risky assets just for the thrill of it. If, however, you have good reason to believe that a particular opportunity off the beaten track is worthwhile, you can still make a small investment in it. The key to doing this safely is to ensure that the bulk of your portfolio is rooted in stable securities – this way, you’ll reap the benefits if you guess right and limit your losses if your bet doesn’t pay off.
- Asset Distribution: How you divide your total investment among different types of assets, such as stocks, bonds, and cash. It’s guided by factors like your goals, risk tolerance, and time horizon.
- Hedging: A technique used to reduce or offset risk in a portfolio, often by holding positions that move in the opposite direction of the primary investment.
- Derivatives: Financial instruments that gain their value from the price movements of an underlying asset, such as stocks, bonds, or commodities.
- Unicorn: A private startup with a valuation of at least $1 billion, noted for rapid growth and often technologically disruptive products or services.
