Portfolio Construction – Part 3

This post is the last in the Money Master Class series – well done for making it to the end!

This post is the last in the Money Master Class series – well done for making it to the end!

We’ll then be taking a few weeks off from the blog, because we are about to launch the online ethical investing portal, yay!

We covered a lot last week, so this week we thought we’d go through some worked examples to show how the theory can be put into practice.

 

Example 1: Saving for the long-term

Peter

Age 25
Starting Investment amount $5,000
Target Investment amount $200,000 in today’s dollars
Cash needs over next 3 years $0
Investment Time Horizon 10 years
Investment Purpose First Home

 

Peter is 25 and has $5,000 in savings.  By the time he is 35, he would like to buy his own home, either to live in, or as an investment.  He thinks a deposit of $200,000 in today’s dollars will be enough for a 20% deposit on his chosen property.

He will not need to access any cash from the savings in this account in the next few years.  Peter is a risk taker and is comfortable taking on the risk of losing money every 4-5 years, because he really wants to maximise his return. 

Peter decides to invest his money in 80% growth assets, and 20% in defensive assets and selects:

Asset Class Percent Amount Estimated Return
Cash 5% $250 2.50%
Bonds 15% $750 4.00%
Shares 80% $4,000 8.00%
Estimated Weighted Return 7.125% p.a.

 

To estimate return, Peter uses a lower rate of return than historical rate of returns, due to the current low interest rate environment.  He will revise his estimated returns by asset class each year, based on current economic conditions.

Calculating Target Investment Amounts

In 10 years time, Peter estimates that $200,000 in today’s dollars will be equivalent to $256,000, using an inflation rate of 2.50%.  Therefore the target at the end of 10 years is $256,000.

If his investments earn 7.125% p.a, peter will need to save $1,400 per month to reach his goal at the end of 10 years.

Choosing Investments

Given his small starting investment amount, and relatively small monthly contributions, Peter decides to invest using exchange-traded funds.  He invests in:

  • 5%                          Cash in a high interest savings account

  • 5%                          Government Bond Fund ETF (very low risk)

  • 10%                        Corporate Bond Fund ETF (medium risk)

  • 40%                        ASX 200 ETF (high risk)

  • 40%                        International Stock market ETF (highest risk)

Peter will monitor the performance of his portfolio via his brokerage account, and intends to check the performance monthly and rebalance his portfolio allocation annually.

Example 2:  Investing for Income Needs in Retirement

Marie

Age 60
Starting Investment amount $500,000
Cash needs over next 3 years $90,000
Investment Time Horizon 30 years
Investment Purpose Retirement Income

 

Marie is 65 years old and has recently retired.  She has paid off her mortgage and has estimated that she will spend $30,000 per year in retirement, and that she will live to 95. 

Based on her calculations, she would like to earn 5% a year on her investments.  Marie is not a big risk taker, but she is worried about her money running out before she retires. Given that her total investment period is 30 years, she decides to invest some of her retirement funds in shares.  Marie therefore decides to put 60% of her money into defensive assets, and 40% into growth assets, split as follows:

Asset Class Percent Amount Estimated Return
Cash 18% $90,000 2.50%
Bonds 42% $210,000 4.00%
Shares 40% $200,000 7.50%
Estimated Weighted Return 5.13% p.a.

Choosing investments

When choosing her investments, Marie decides to put $90,000 in cash because she will need access to this cash to live on over the next three years.  She splits this cash between a high interest savings account and a series of term deposits:

  • 15,000                   High Interest Saving Account

  • 15,000                   6 month term deposit

  • 15,000                   1 year term deposit

  • 15,000                   18 month term deposit

  • 15,000                   2 year term deposit

  • 15,000                   2.5 year term deposit

  • 15,000                   3 year term deposit

She is concerned about fees, so decides to invest in both bonds and shares via exchange-traded funds.  She likes the idea of receiving dividends on her shares, so decides to put a portion of her investment into high dividend paying shares.  She invests:

  • 30%                       Government Bond Fund ETF (very low risk)

  • 10%                       Corporate Bond Fund ETF (medium risk)

  • 15%                       High Dividend ETF (high risk)

  • 15%                       ASX 200 ETF (high risk)

  • 10%                       International Stock market ETF (highest risk)

Marie will monitor the performance of her portfolio via her brokerage account, and intends to check the performance monthly, although she has decided to only make changes to her portfolio allocation and rebalance annually.

That’s it for the series!  We’ll be back in a few weeks for our next series, all about ethical investing.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Portfolio Construction – Part 2

Last week we looked at the relationship between risk and return, and how that impacts the asset classes you might invest in.

Last week we looked at the relationship between risk and return, and how that impacts the asset classes you might invest in.  This week we continue with our step-by-step guide to constructing your portfolio.

 Step 4:  Which asset class will you invest in?

Once you have decided how much risk you are prepared to take, you can put together a suitable combination of growth and defensive assets to suit your risk profile.  Let’s say I am a balanced investor, there are a number of different ways to construct an investment portfolio of 30% defensive and 70% growth assets:

  • 30% cash and 70% shares

  • 10% cash, 20% bonds, 70% shares

  • 15% cash, 15% bonds, 50% shares, 20% property

Which asset mix you choose will depend on your time horizon, how comfortable you are investing in each asset type and how much money you have to invest.  For example, investing in residential property requires a large amount of money upfront, making it unavailable to many investors.

Step 5: Which investments will you make?

Once you have decided which assets to invest in, the next decision is how to access each investment.  Will you put your cash into a high interest savings account, or a term deposit?  Will you invest in equities via a managed fund, or will you invest via an exchange traded fund? 

If you are unsure, it is worth going back over the previous blog posts dedicated to each asset class to decide how you want to access your investments

Step 6: How will you monitor the investments?

Once you have made your investments, you will need to monitor them to ensure they are performing in line with your expectations.  You should review the performance of your investments at least semi-annually. 

Keep in mind that investment performance can be very volatile, don’t be too hasty to sell your investments.  Only consider selling if something fundamental has changed in your investment strategy, or your goals, which makes the investment split inappropriate.

Step 7: How often will you rebalance your portfolio?

Portfolio rebalancing refers to bringing your portfolio back to its initial asset allocation.  For example:

  • You decide to invest your $10,000 portfolio in 30% bonds, and 70% equity

  • 1 year later, the share market has risen 20%, and the bond market has risen 5%

  • At the end of year 1 you now have $8,400 in shares and $3,150 in bonds.  This means that your portfolio is now invested 73% in shares and 27% in bonds.

  • To rebalance your portfolio, you need to sell the extra 3% in shares and reinvest them in bonds.

We recommend portfolio rebalancing at least annually.  Research has shown that portfolio rebalancing increases returns, and decreases risk, making it a worthwhile exercise.

There is a lot of information in the above post, next week we go through some worked examples to help put the theory into action.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Portfolio Construction – Part 1

Now that we’ve reviewed all the different asset classes, it’s time to put all that learning together and construct your investment portfolio.

Now that we’ve reviewed all the different asset classes, it’s time to put all that learning together and construct your investment portfolio.  We’ve broken it down, step by step.

Step 1:    How much cash will you need?

The first step in constructing your portfolio is determining how much money you will need to hold in cash.  You should hold in cash:

  • Any money that you will need to access in the next 3 years
  • Sufficient cash to pay any costs associated with your investment portfolio

If you have retired, the amount you need in cash would be your next 3 years living expenses.  The reason for this is that you don’t want to be in a situation where you have to sell your assets in a down market to cover your  expenses.

Step 2:  What is your investment time frame?

Determining your investment time frame will help determine which assets to invest in.  The time frame is how long you expect the assets to be invested for, i.e. how long before you’ll need the money you’ve invested.

In terms of appropriate asset classes by time frame, broadly speaking:

Time Frame Asset Class
0-3 years Cash
3-5 years Bonds
5+ years Property / Shares

Step 3:  How much risk are you prepared to take?

As we mentioned in earlier posts, your goal in constructing a portfolio is to maximise your return and minimise risk.  It is not possible to earn a high return with low risk, so when you consider your target return, you will also need to consider how much risk you are prepared to take.  Below we have set-out historic returns by asset class, and an indication of risk:

Asset Class Asset Type Risk Average Return p.a. over 20 years*
Cash Defensive Low 3.40%
Australian Bonds Defensive Low-Medium 6.80%
Residential Property Growth Medium-High 10.50%
Australian Shares Growth High 8.70%
International Shares (hedged) Growth Highest 7.60%

* 20 years to Dec 2015.  Source: 2016 Long-Term Investing Report, Russell Investments

Theoretically, the higher risk products should have the highest return, however this won’t hold true over every time period.

ASIC also has some useful information on their website about the expected risk of different portfolio types, which we have summarised here:

Portfolio Purpose Defensive Assets Growth Assets Risk Expect a loss Expected Return Value of $10,000 after 5 years
Growth 15% 85% High 4-5 years in 20 6.20% $13,500
Balanced 30% 70% Medium 4 years in 20 5.70% $13,200
Income / Conservative 70% 30% Low 0 years in 20 4.20% $12,300

 

Everyone wants to maximise their return, so it is easiest first to focus on risk.  How much money are you prepared to lose? As set out in the table above, would you be prepared to invest in a growth portfolio and take on the risk of losing money every 4-5 years out of 20? Or would you rather take a lower 4.20% return and preserve your capital?

Generally speaking, the younger you are the higher your ability to take on risk.  If you 25 and investing for retirement, then a high growth portfolio may be appropriate because losing money every 4/5 years isn’t an issue, given that you won’t be accessing the money for 40 years.  However, if you are 25 and saving for a home deposit, then you may not be comfortable at the thought of losing your hard earned savings, meaning that you would instead consider a conservative portfolio.

These are decisions that only you can make, and it will depend on your stage of life and what you are using your investment savings for.

Once you’ve completed the steps above, you are ready to choose your investments.  We’ll cover that next week.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Investing In Alternatives – Part 2

Most people think that a company has made it when it is listed on the Australian stock exchange, but how can you invest before a company reaches this milestone?

Most people think that a company has made it when it is listed on the Australian stock exchange, but how can you invest before a company reaches this milestone?

The answer is private equity, which is another asset class usually grouped in the bucket called “alternatives”.

Private Equity

When you purchase shares on the Australian stock exchange, you are purchasing shares in publicly listed companies.  That is, they are listed for purchase by the public, on the public stock exchange.  When a company is listed publicly there are certain rules and regulations that must be met,  designed to ensure that the company regularly reports to the public and is transparent about their company management.

However public companies are only one part of the company landscape, there are also a number of other companies that are not listed on the Australian Stock Exchange.  These companies are known as private companies.

What:  Private equity are shares in privately held companies, i.e. those companies not listed on the stock exchange.

Why:  Privately held companies tend to be on a higher growth trajectory than more established, listed companies.  Some investors look to find private companies that have not yet met their full potential, with the view of getting in early, adding value to the company and eventually taking the company public and realising a profit.

How:  Investing in privately held companies is a very specialised area.  It requires:

  • Finding deals:  to invest in privately held companies, you have to be able to find ones that are suitable.  This can be tricky, as these companies are not listed in the same way that companies on the ASX are listed.

  • Analysing deals:  Companies listed on the ASX have to meet certain disclosure requirements in terms of the information they provide to investors.  Additionally,  the performance of the largest companies are covered by analysts who will provide a view on whether the company is a good investment.  The public infrastructure to analyse a company’s performance does not exist for private companies.  Instead it is up to you to ask the right questions, review the right information and analyse the data yourself.

  • Monitoring Performance:  Once you purchase shares in a private company, you will need to  monitor the performance.  The disclosure of performance data is not regulated the same way public company data is.  It is up to you to request the right information on a timely basis.

  • Large sums of money:  Many investments in private companies are restricted to wealthy investors and require a minimum investment sizes of upwards of $500,000.

For the reasons listed above, it is easiest to invest in private equity via either:

  • Exchange Traded Fund:  There are now a number of exchange traded funds that provide access to private equity investment.

  • Managed Fund:  You could also invest in a professionally managed private equity fund.  One thing to note about these funds, the fees are likely to be higher than your standard share fund.  This is because of the specialised nature of private equity investment.  A standard fee structure is known as 2/20, which means that the manager receives a 2% management fee and a 20% share of any profits that the manager makes above a set benchmark.

When investing privately it is very important to invest with someone that has specialised knowledge of the industry, and some kind of advantage in finding the best companies first. This is because private equity investing is very risky, and very competitive.   Next week we’ll take a closer look at some of the risks of investing in private equity.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.