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.

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.

Asset Classes & Investment Styles

Once you’ve decided to start an investment portfolio, the next step is to decide what to invest in.

Once you’ve decided to start an investment portfolio, the next step is to decide what to invest in.  The average person will pick a handful of stocks and hope for the best, here we explain some more sophisticated techniques for constructing your investment portfolio.

Asset Class Selection

Your first decision is which asset classes to invest in.  Your broad choices are set-out below, each week we are going to delve into one of the asset classes and explain exactly how you can invest in it, and why you may want it to form part of your portfolio:

Asset Class Prupose Risk Time Frame Products
Cash Keep some money available for short term cash needs Low Short term High interest savings accounts, term deposit, cash exchange traded funds
Bonds Earn some interest while keeping risk low Low – High Short to medium term Government bonds (low risk) to junk bonds (high risk). Bond exchange traded funds, actively traded bond funds
Property Earn income via rent and increast the value of your investment over time through property price increases Medium – High Medium to long term Directly through purchasing a property. Indirectly through a property exchange traded fund, a property managed fund, or through shares in property companies
Australian Shares Earn income via dividends and increase the value of your investment over time through share price increases High Medium to long term Direct shares, equity exchange traded funds, equity actively managed funds
International Shares Increase the value of your investment over time and spread your risk globally, rather than being concentrated in the Australian market only High Medium to long term Direct shares, equity exchange traded funds, equity actively managed funds

Investment Style: Passive or Active

Your next decision is which investment style you prefer:

  • Active Management: Active managers believe that they can outperform the market by picking the best investments.  Active managers are likely to charge a higher fee for this skill. 

  • Passive Management:  Passive managers believe that it is not possible to beat the market.  Instead of picking individual stocks, they believe it is better to be invested in the whole market.  Passive management fees are lower than that of active managers.

Your decision about investment style will determine how you invest.   If you believe in active management then you can either:

  • Do the research and make the investments yourself – we only recommend this if you feel confident that you have the time and technical skills required to do the necessary due diligence on each investment, and that you have some kind of advantage (e.g. in depth knowledge of an industry) over professional fund managers.

  • Pay a fund manager – You can outsource the investment decision by paying a fund manager to manage your money.  The cost is typically 1 – 2% of the amount that you invest.

If you decide to follow a passive investment strategy then your main investment tool will be exchange-traded funds (“ETF”).   An ETF gives you access to an entire market (e.g. the top 200 shares in the Australian market, known as the ASX200) through one single purchase on the stock exchange.  Fees for an ETF are lower than for an actively managed fund, they are more likely to be between 0.10% – 0.50%.

In deciding whether to follow an active or a passive strategy, it is worth considering this semi-annual report by S&P which shows that in most asset classes, the majority of active managers do not beat the market.  This report suggests that a passive management style can potentially be better for your portfolio.  The key exception is in Small Cap stocks (i.e. smaller companies listed on the stock exchange) where it has been shown that 60% of Small Cap fund managers have outperformed the market over the last 5 years.

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 and before acting on the advice.