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.

Investing in Alternatives – Part 1

Over the last few weeks we have covered the major asset classes that investors include in their portfolio, namely cash, bonds, shares and property.

Over the last few weeks we have covered the major asset classes that investors include in their portfolio, namely cash, bonds, shares and property.  “Alternatives” is an all- encompassing term that includes anything else.  

This week we look at one of the most well known Alternatives, commodities.

Commodities

Some people like to include exposure to commodities within their portfolio, the most popular with non-professional investors tend to be gold and oil.

What:  Commodities are tradeable goods.  Commodities include metals (e.g. silver, gold), energy (e.g. oil), livestock (e.g. pork bellies) and agriculture (e.g. coffee, corn).

Why:     People invest in commodities due to a view they have on the market.  For example, if you believe that pork bellies are undervalued, then you need to get out more and stop researching the price of pork bellies!  Or you could try investing in them to benefit when the price rises. 

Other commodities, notably gold, are used to express a view about risk.  Generally when global risks increase, the value of gold increases because it is an absolute store of value.  That is, it has value in and of itself, and in times of crisis the price of gold rises.  During the period from 2007 until the end of 2010, the price of gold increased at an average annual rate of c.23%.

How:  Generally speaking, it is quite difficult to invest in commodities directly, because they trade in very large parcels that make it hard for retail investors to participate.  The easiest commodity to invest in directly is gold.  For example, if you want to go old school you can head to the Perth Mint and buy yourself some gold coins.  Other commodities, like oil, are a little harder to buy and store directly.

The easiest ways to invest in commodities are:

  • Share Purchases:  Although you cannot purchase all commodities directly, you can directly purchase shares in a company that trades in that commodity.  For example, to get exposure to gold you could invest in a gold mining company.

  • Passive Funds: There are exchange-traded funds available that will give you exposure to commodities, e.g. a Gold ETF or an Oil ETF.  The price of these ETFs will rise when the price of the underlying commodity rises, and vice versa. 

  • Managed Fund:  There is also the possibility of investing in a managed fund, where the manager specialises in a particular commodity. 

Risks:  Investing in commodities is purely a price play, you will only benefit if the price of the commodity increases.  Unlike shares, bonds or property, there is no income component of commodity investing (i.e. you do not receive a dividend, interest payment, or rent). 

Commodity investing can be complex and the prices are very volatile.  The people that trade and invest in commodities are highly specialised, for example the people that invest in gold do it day in and day out, for their whole career.  It is not an asset class that is recommended for novice investors.

If you want to invest in commodities, then ideally it should form only a small part of your portfolio (e.g. 5%) due to the risks, complexity and specialised knowledge required.

Next week we are going to look at another common Alternative, 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.

Stepping on to the property ladder

Now that we’ve looked at some of the benefits, and risks, of investing in property, it’s time to consider how to invest.

Now that we’ve looked at some of the benefits, and risks, of investing in property, it’s time to consider how to invest.

How can I invest in Property?

There are a number of ways to invest in property, below we consider some of the most common.

Directly 

This is the road many people go down, purchasing a property for investment purposes.  Purchasing directly allows the owner to take advantage of negative gearing, it also allows you to choose and inspect the property yourself. 

The tax benefits need to be weighed against some of the downsides:

  • You need a lot of money to enter the property market, unlike the share market where you could start with a very small (e.g. $100) initial investment amount.
  • The purchase costs can be high (including the deposit, inspection costs, solicitors’ fees and stamp duty).
  • The ongoing management costs are high, including agent’s fees and maintenance costs.
  • By investing in one property in one location you are putting all your eggs in the one basket and concentrating your risk in that location
  • You can’t sell part of a property, it is either all or nothing.  Whereas with an investment in shares, you can sell part of your investment portfolio.

Indirectly via shares

Instead of buying directly into property, it is possible to get access to the property sector by buying the shares of companies that operate in the property sector.  This could include companies involved in property development, real estate management, or the supply of building materials.  Investing in the shares of property companies will not allow you to gain all the benefits we outlined above, but it is an option worth considering if you do not yet have the funds to purchase a property.

Exchange Traded Funds

There are a number of passive funds that provide access to property, including ETFs that focus on different classes of property (e.g. office, shopping centres, industrial).  The benefit is that you get access to a diversified portfolio, however the downside is that you do not get the benefit of negative gearing, or the security that comes with personally owning a tangible asset.

Unlisted Managed Funds

Another option is paying a fund manager to invest in property.  Property managers generally specialise in one particular area, whether it be residential, or commercial, or industrial property.  The downside is that this will cost you between 1-2% p.a, and you do  not get the benefit of negative gearing, or the security that comes with personally owning a tangible asset. 

REITs

A REIT is a real estate investment trust and provides a way for investors to access property investment, without having to purchase the entire property.  The real estate investment trust owns and manages the property, and the investor gains access to the assets of the trust through a purchase on the Australian stock exchange. 

Each REIT usually has a particular investment focus, e.g. shopping centres, office buildings.  The performance of the REIT is dependent on the skills of the manager who is picking the underlying assets and managing them, it also depends on the amount of debt the REIT has, higher debt leads to higher risk.  Before purchasing a REIT, make sure you do your due diligence on who manages the REIT and the financial position of the REIT.

Another point to note regarding REITS is that although they might feel more liquid because they trade on the stock exchange, REITs are still exposed to property and the underlying investments can be illiquid.  A number of REITs were frozen (i.e. you couldn’t get your money out) during the GFC.

According to the SPIVA report  over 75% of actively managed Australian REITs under performed the passive index over the last 10 years.

So there you have it, a number of options for you to consider if you feel that property is an area you would like to invest in.  Next week we’re moving on to the exciting, and all-encompassing world, of “alternatives”.

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.

Property Q&A

The property market has outperformed the share market over the last 10 years, so why not jump straight in?

The property market has outperformed the share market over the last 10 years, so why not jump straight in?  This week we look at the risks of investing in property.

What are the Risks of investing in property?

There are lots of benefits to investing in property, but make sure you understand the risks before making what is likely to be the largest investment decision of your life.  Below we take a look at the key risks.

Liquidity: We have spoken about liquidity previously, it refers to the ability to turn assets into cash.  Shares are very liquid because they can be sold on any business day.  However selling a property can take some time, if the market is falling it is very hard to get out quickly.  Once the market has fallen, it can take years to sell certain kinds of properties (e.g. rural / remote properties, bespoke properties, commercial buildings that no longer have tenants).

Also, when selling property it is all or nothing, you can’t just sell part of it.

Volatility:  Property is classed as a growth asset, not a defensive asset (which include cash and bonds) because property values are volatile.  The volatility of the share market is very apparent, because the prices move all day every day, and there is clear visibility of the share price movements.  The property market is also continually moving, there is just less transparency around pricing, and therefore less visibility of the movements.   A study found that the standard deviation (a measure of volatility) of direct property investing over the period from 1985 to 2012 was close to 10%, compared to 20% for the stock market.  This data suggests that property investing is less volatile than investing in the stock market, however volatility is still present.

Leverage: One of the benefits of investing in property is the ability to borrow money to do so, which allows you to leverage you initial investment to purchase a more expensive property than you could afford without borrowing.  The downside of leverage is that it introduces additional risk.  If you invest $50,000 in the stock market, the most you can lose is $50,000.  If you use $50,000 as a down payment and borrow $400,000, then you get an asset worth $450,000, however you now owe $400,000 to the bank and are personally liable for making sure the money gets repaid.

Lack of diversification:  Due to the large cost of purchasing property, it is difficult to create a diversified portfolio by investing directly.  If you own only one residential investment portfolio, you are heavily dependent on the performance of that geographic location, which means a very concentrated portfolio.  This issue can be overcome by investing via a fund, however then you do not have direct ownership or control over the asset, and are unable to benefit from negative gearing.

Management Costs: Investing in property comes with high management costs for the owner of the asset.  This includes agents fees, maintenance costs and other running costs (e.g. utilities, council rates, land tax).  These fees tend to result in much higher management costs for a property portfolio than a share portfolio.

What goes up must come down: There has been a lot of talk in the press about the Australian market being over-valued.  Whatever your view, it is worth remembering that market conditions change; house prices will eventually come down, and interest rates will eventually go up.  Here’s a good overview of the last housing crash, including interest rates of 17.5% – yikes!

 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.

What are the risks of investing in property?

The property market has outperformed the share market over the last 10 years, so why not jump straight in?

The property market has outperformed the share market over the last 10 years, so why not jump straight in?

This week we look at the risks of investing in property.

What are the Risks of investing in property?

There are lots of benefits to investing in property, but make sure you understand the risks before making what is likely to be the largest investment decision of your life. Below we take a look at the key risks.

Liquidity

We have spoken about liquidity previously, it refers to the ability to turn assets into cash.  Shares are very liquid because they can be sold on any business day.  However selling a property can take some time, if the market is falling it is very hard to get out quickly.  Once the market has fallen, it can take years to sell certain kinds of properties (e.g. rural / remote properties, bespoke properties, commercial buildings that no longer have tenants).

Also, when selling property it is all or nothing, you can’t just sell part of it.

Volatility

Property is classed as a growth asset, not a defensive asset (which include cash and bonds) because property values are volatile.  The volatility of the share market is very apparent, because the prices move all day every day, and there is clear visibility of the share price movements.  The property market is also continually moving, there is just less transparency around pricing, and therefore less visibility of the movements.   A study found that the standard deviation (a measure of volatility) of direct property investing over the period from 1985 to 2012 was close to 10%, compared to 20% for the stock market.  This data suggests that property investing is less volatile than investing in the stock market, however volatility is still present.

Leverage

One of the benefits of investing in property is the ability to borrow money to do so, which allows you to leverage you initial investment to purchase a more expensive property than you could afford without borrowing.  The downside of leverage is that it introduces additional risk.  If you invest $50,000 in the stock market, the most you can lose is $50,000.  If you use $50,000 as a down payment and borrow $400,000, then you get an asset worth $450,000, however you now owe $400,000 to the bank and are personally liable for making sure the money gets repaid.

Lack of diversification

Due to the large cost of purchasing property, it is difficult to create a diversified portfolio by investing directly.  If you own only one residential investment portfolio, you are heavily dependent on the performance of that geographic location, which means a very concentrated portfolio.  This issue can be overcome by investing via a fund, however then you do not have direct ownership or control over the asset, and are unable to benefit from negative gearing.

Management Costs

Investing in property comes with high management costs for the owner of the asset.  This includes agents fees, maintenance costs and other running costs (e.g. utilities, council rates, land tax).  These fees tend to result in much higher management costs for a property portfolio than a share portfolio.

What goes up must come down

There has been a lot of talk in the press about the Australian market being over-valued.  Whatever your view, it is worth remembering that market conditions change; house prices will eventually come down, and interest rates will eventually go up.  Here’s a good overview of the last housing crash, including interest rates of 17.5% – yikes!

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.

What’s to love about property?

Property is one of the most loved asset classes in Australia, and the state of the property market is always in the press, whether it’s going up or down.

Property is one of the most loved asset classes in Australia, and the state of the property market is always in the press, whether it’s going up or down.

This week we look at the whys of investing in property.

Why invest in property?

Bricks and Mortar

Many people invest in property because they like the feeling of security that comes with having a tangible asset.  They also like the ability to see the asset for themselves.  It is a lot easier to conduct due diligence when you are purchasing an investment property, which you can visit and inspect, than it is to conduct due diligence on a company, where you are reliant on the information that the company provides, and your ability to ask the right questions to analyse the stock. 

Leverage

Most people borrow money to invest in property, meaning that they slowly build up ownership of an asset that they could never afford outright.  It is also possible to borrow to invest in shares, however property borrowing is less risky as you are generally not subject to  margin calls.

Income

Another benefit of investing in property is the income that it provides, in the form of rent.  Rental income is a common feature across all types of property investment, whether it be residential, office, warehouse or retail.

Capital Growth

In addition to rental income, property also offers capital growth, through appreciation of property prices.  Over the last 20 years, property has on average returned 10.5% p.a, this is the total return and includes both income and capital gains.

Tax Benefits

Certain kinds of property investing comes with tax benefits, namely negative gearing.  If you purchase a property for investment purposes, you are able to deduct the cost of managing the property and owning the property, including the interest on your mortgage.  This results in a reduced taxable income and can make property investing more affordable.

Next week we look at how you can invest in property, there are many more options that simply buying a house!

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.

International Shares

Last week we covered Australian equities. This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.

Last week we covered Australian equities.  This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.

Why invest in international shares?

One of the main reasons to invest in international shares is diversification:

Sector Diversification: In Australia, approximately 60% (by market capitalisation) of the top 100 companies operate in a very narrow set of industries, namely financials, mining & materials, and energy.  If you invest only in the Australian market, your portfolio may lack sector diversification. 

By investing internationally, you get access to other sectors. For example, the top sector in the US is Information Technology, which accounts for over 20% of the 500 largest companies in the US.  In Australia, information technology accounts for only 0.85% of the 100 largest companies.

Geographic Diversification:   If you invest only in the Australian market, the performance of your portfolio will be tied to the performance of the Australian economy.  This can be problematic because your financial well being (i.e. your ability to find work, buy a house, meet interest repayments) is also tied to the performance of the Australian economy. 

Investing internationally helps to diversify your investment risk, by providing access to markets outside of Australia.

How can I invest in international shares?

There are a number of ways to invest in international shares:

Directly:  You could pick a handful of stocks and try to invest directly.  This is a little tricky, because foreign stocks are listed on foreign stock exchanges, which are not easily accessible.  Some brokers in Australia do allow you to purchase stocks listed on certain foreign exchanges. 

 However, before you do this it is important to consider the impact of foreign exchange on your investment.  If your international share portfolio rises by 10%, but the Australian dollar appreciates by 10%, then your net return will be 0.  It is hard to manage this foreign exchange rate risk when you purchase shares directly.

Exchange Traded Funds:  It is possible to invest in international equities via an exchange traded fund (“ETF”).  This means that you can purchase the international equity ETF on the Australian stock exchange (the same way you would a share) and get access to a number of international stock markets.  The upside is that you get access to a diversified international portfolio, through a purchase in Australia, and you can choose a hedged portfolio (more on that below) to minimise your foreign exchange rate risk.  The downside is that you will pay a fee for this management, usually around 0.3% to 0.5%p.a.

Managed Fund: Another option is to invest via a fund manager, this allows you to invest in a professionally managed portfolio of international stocks.  This is a simpler option that investing directly in a number of different stock exchanges, and you get access to professional investment expertise, including expertise in managing foreign exchange rate risk. 

 The downside is that this will cost you between 1-2% p.a.   According to the SPIVA report just over 10% of international managed funds in Australia outperformed the index over the last 10 years.

Too many international shares?

International shares are an important part of a portfolio, particularly for those who are able to take on a higher level of risk, however they should not form 100% of your portfolio.  This is because international shares have all the same risks as Australian shares, plus the additional risk of foreign exchange fluctuations. 

When you invest internationally, you are selling Australian dollars and buying the currency of the investment.  This means that the value of your investment will fall in Australian dollar terms when the Australian dollar rises, so you are exposed to the risk of the Australian dollar appreciating.

If you invest via a managed fund, or an ETF, you are likely to have the option to hedge your foreign exchange rate risk.  If you go with a hedged option, the fund manager will pay a fee to lock in a set foreign exchange rate.   This means that you are protected if the Australian dollar appreciates, but you will miss any upside if the dollar depreciates.

Hedging does not eliminate foreign exchange rate risk, instead you are paying a fee (via the cost of the hedge) to manage it.

The decision of whether or not to hedge is a very personal one and will depend on your ability and willingness to take on risk.  Foreign exchange can be very volatile, if you do not like volatility you should consider hedging any foreign exchange rate risk in your portfolio.  The chart below shows the Australian Dollar / US Dollar exchange rate over the last 10 years, as you can see the rate has been very volatile.

 

A further point to consider with international shares is diversification.  If you invest in a handful of international stocks in the US technology industry, then you have added only a small additional layer of diversification to your portfolio.  To get the largest diversification benefit from international stocks, try to avoid concentrating your stocks in a particular industry or country.

Next week we are going to cover another popular asset class in Australia, Property.

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.