Four eggs in six baskets. Can you have too many investment pots?

Eggs in a basket
For financial professionals only

One of the blessings of modern platform technology for advisers has been the ability to easily set up different pots for different financial planning goals and then select appropriate solutions and appropriate Risk Grades for the individual client concerned.

There are two really big advantages to being able to do this. The first is that when there is real conflict between goals there is at least clarity about how much capital has been finally allocated to each one. For example, in balancing the tensions that exists between ‘Retiring early’, ‘Paying off the Mortgage’ and ‘Kids at University’.

The second is the tangible emotional benefit that comes with going with the grain of our processes for ‘mental accounting’. In everyday terms this has something to do with a strong sense that ‘keeping all your eggs in one basket’ isn’t a clever plan. Within the academic realm of behavioural economics, this aspect of our thinking forms part of the study of the ‘Behavioural Life Cycle’ hypothesis. A considerable body of econometric research suggests we tend to divide our focus between current income, current assets and future income. Or bank account, investments and pensions, if you like. We naturally think in terms of pots and want to treat them as strictly separate.

Unsurprisingly, our innate response to complex financial challenges isn’t perfect. One of the real dangers of going too far with dividing money into discrete pots is that wealth can be broken down into so many sub-divisions that your overall portfolio begins to lose the long term risk/return benefits of rebalancing and diversification. Again, this topic has been much studied by the academics who have pointed out that when we are asked what we’d like in future, we tend to ask for a wider selection of options than it can be proved would keep us happy with if we were asked in sequence, over time. This is studied under the heading of ‘naïve diversification’. For example, given a choice of two financial plans, one with six investment pots and another with only four, most would probably lean to the ‘better’ one with the six separate pots. Although it might feel good, it might not make the most sense.

One of the ways that relatively straightforward cash flow modelling can help to overcome this tendency is by illuminating what amount of notional present capital and what projected future returns might cover the entirety of the client’s planned spending goals. In the situation of a client ‘at retirement’ this equation also quantifies the amount of their surplus capital or ‘capacity for loss’ over the amount they actually need. And, looking at everything in the round brings the discussion back to the recommendation of an overall risk level and how high that can sensibly go. Why does this help?

Objectively, using excess capital to provide increasing levels of unnecessary certainty is a luxury, and something that may only give emotional benefit. It cannot help you retire early, pay off the mortgage, help the kids through University or get on the housing ladder. Advice can do wonders by keeping the focus on the big picture and the overall investment strategy – among the details of standalone goals and investment tactics.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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