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 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.

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.

How to add international exposure to your portfolio

Last week we considered the pros and cons of adding international stocks to your portfolio, this week we look at how.

Last week we considered the pros and cons of adding international stocks to your portfolio, this week we look at how.

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.

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.

The pros and cons of going international

Last week we covered Australian equities.  This week we cover International shares and the pros and cons of adding them to your portfolio.

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.

What are the risks of investing internationally?

Lack of familiarity

If you’re investing in Australia, there is a good chance that you have used the services of the company you are investing in, or at least be familiar with them.  This is a good starting point for the due diligence an investor should complete prior to investing.

If you are investing offshore, the due diligence is a little harder as you don’t have “local knowledge”, like what’s the difference between Walmart and Home Depot?  or who shops at Whole Foods? You become entirely reliant on research reports to form a view on a company, instead of first hand knowledge.

Foreign Exchange

Another risk with investing internationally is foreign exchange. 

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 (going up).

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.

SMLXL

Source: Yahoo Finance

The USD is one of the most frequently traded currencies.  If you are investing offshore, try to stick to the liquid currencies (USD, Euros, Sterling) and avoid the smaller, less frequently traded currencies.

Perceived Diversification

Investing internationally should result in a more diversified portfolio, if you make the right investments.  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 look at how to add international exposure to your portfolio.

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.

 

Shares, Stocks or Equities?

This week we are going to talk about shares, probably the most well known kind of investment.

This week we are going to talk about shares, probably the most well known kind of investment. 

Shares are also known as equity, or stocks.  We will use all three terms interchangeably.

What are Shares?

When you buy shares in a company, you are buying part of the company, meaning that you become a part owner of the company. As a part owner you have the right to:

  • Share in the profits of the company:  Any profits that are distributed to shareholders will be paid to you as a dividend.  Dividends are usually paid semi-annually.

  • Vote:  When key decisions are made in the company, as a shareholder, you will have the right to vote.  For example, you may get to vote at the Annual General Meeting (AGM) about which directors to elect, or how much company executives should be paid.

Shares are very different from bonds.  When you invest in bonds, you are lending money to a company.  When you purchase shares, you are becoming a part owner of a company.

Why Invest in Shares?

Shares are a key part of any investment portfolio. The top reasons why you would invest in shares are:

Capital Growth: Australian shares generated a higher investment return than either cash or bonds, with an average per annum return over the last 20 years of 8.70%.  Investing in shares helps grow your investment (also known as capital) over time and achieve a portfolio growth rate that is ahead of inflation. 

Dividends and Franking Credits: Some people invest in shares for the income provided by dividends.  A further benefit, when you invest in Australian shares, is the franking credits that some shares provide. 

A Franking Credit is a credit you receive for the tax that a company has already paid. A company will usually pay tax on its profits at a rate of 30%, if the dividend you receive is franked, you will receive a tax credit for the amount of tax that the company has already paid on that dividend.  This will be particularly beneficial if your marginal tax rate is below 30%.  For example, if you hold the shares in your superannuation account:

  • Prior to retirement (i.e. during the accumulation phase of your super):  Any income you receive is taxed at 15%.  This means that if you invest in shares that pay a fully-franked dividend, you’ll receive a tax credit of 30% and only pay tax of 15%, leaving you 15% better off.

  • In Retirement (during the pension phase): You don’t pay any tax on the income generated from your superannuation account.  If you invest in shares that pay a fully-franked dividend, you’ll get the full benefit of the 30% tax credit.

How to Invest in Shares

When investing in shares you have a number of options:

  • Invest Directly:  You could pick a portfolio of stocks to invest in.  If you go down this route you’ll need to pick at least 20 stocks to ensure that you have some diversification in your portfolio, with the stocks spread between different industries and geographies.  You’ll also need to keep on top of the performance of these stocks to make sure that their returns are in line with your expectations.

  • Invest via a Passive Fund:  There are a number of exchange-traded funds (ETFs) available which give you access to different segments of the market.  For example, you could purchase an ETF that gives you access to the ASX200, which is the largest 200 companies on the Australian Stock Exchange.  There are also ETFs available by sector (e.g. healthcare) or by size of company (e.g. small cap stocks), or by geography (e.g. international ETFs).  To invest via an ETF you are likely to pay a fee of between 0.10 – 0.50%p.a.

  • Invest via a Managed Fund:  Alternatively, you could pay a fund manager 1 – 2% with the belief that they will pick well-performing stocks and outperform the passive funds or index.  According to the SPIVA scorecard, only 26% of fund managers outperformed the ASX 200 over the last 5 years.

Interestingly, the majority (52%) of managers that focused on small and mid-cap stocks (which we’ll cover in more detail next week) outperformed the market over a 5 year period.This suggests that it may be worthwhile using a passive fund to invest in the ASX200, and a fund manager to access small and mid-cap stocks.

Too many shares?

Over the last 20 years, shares have generated an average return of 8.70% per year, so why not invest 100% in shares?  The reason is risk.  A higher return is always accompanied by higher risk. 

The chart below shows the performance of the stock market over the last 10 years, as you can see the market still hasn’t returned to the highs of 2008. 

 

 

In the period from November 2007 to end of February 2009, the market dropped by over 50%.  That means that if you invested $10,000 in the whole of the market on 31 October 2007, by 1 March 2009 you would be left with $4,951 left.  As at 31 December 2016 your initial $10,000 investment would be worth $8,387.  Keep this in mind each time you are considering investing in shares.  They are an important part of an investment portfolio, but shouldn’t form 100% of it.

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.

Shares Q&A

There are lots of different kinds of shares, below we outline some of the common share terminology for the various categories.

What kinds of shares can I buy?

There are lots of different kinds of shares, below we outline some of the common share terminology for the various categories.

Large, Mid and Small Capital Stocks: You may have heard these terms before.  Large, Mid and Small refers to the market value of the company (also known as share capital).  In Australia:

  • Large Cap Stock: The top 50 largest companies in Australia

  • Mid Cap Stock:  The 51st to 100th largest companies in Australia

  • Small Cap Stock: The 101st to 300th largest companies in Australia

The definitions above are based on the S&P/ASX indices series.  Some fund managers may use a different definition based on a set market capital, rather than a simple ranking.  If you are investing in a Small Cap fund it is best to check what definition is being used.

Generally large cap stocks are the most liquid (which means that are easy to sell and usually have a low differential between the buy and sell price).  Small cap stocks can be less liquid and may be riskier, as they are usually less established companies, when compared to those in the Large Cap indices.

Due to the higher risk in small cap stocks, you should expect a higher return when investing in them.

Value Stocks:  A value stock is one that appears to be undervalued based on the fundamentals of the company.  Some stock analysts will look at the company fundamentals, determine the fair value, and then purchase a stock if it is below this fair value.  This is value investing.

Growth Stocks:  A growth stock is one whose earnings and revenue are expected to increase at an above market rate.  Growth stocks tend to be newer companies who are in the early growth phase.  Typically such stocks do not pay dividends, as they are reinvesting the money in further growth.  You would invest in a growth stock if increasing the value of your investment is your key concern, rather than dividends or capital preservation.

Private Equity:  So far, all the shares that we have been talking about are listed on the stock exchange, and are therefore available to the public.  However it is also possible to buy shares in companies that are not listed on the stock exchange, these shares are called Private Equity as they are not available to the public.  Purchasing private equity is a very specialised field, and it is very risky.  In later weeks we are going to cover private equity in more detail.

What are some of the key risks of investing in shares?

There are two broad categories for risk for investing in shares:

Specific Risks: Specific risk is the risk that belongs to each stock.  For example, if you have invested in Company A, a technology stock listed on the Australian stock market then you have:

* Company Specific RiskThis covers risks related specifically to Company A.  For example a movement in their share price due to a recent release of their sales data. 

* Sector Specific Risk:  Company A is a technology company, if news is announced that negatively impacts the technology sector, as part of that sector, Company A’s stock price is likely to fall.  This is sector specific risk.

* Geographic Specific RiskCompany A is an Australian company.  If news is announced that negatively impacts Australian stocks (e.g. weak employment data), Company A’s stock price is likely to  fall. This is geographic specific risk.

Market Risks:  Market risk is the risk that comes with being part of the stock market.  If there is negative news, then the whole market is likely to react negatively and stock prices will fall.  It doesn’t matter if you are invested in Company A, or Company B, all stock prices are likely to move in the same direction.

The above highlights some of the risks of investing in stocks.  It is important to remember that there is no bottom to where a stock can fall.  If a company runs into financial trouble, debtors (including bond holders) get paid first, and shareholders get paid last.  This means that in an extreme case, your shares could be worth $0.  Prior to making an investment, it is important to consider all the risks of that particular stock, and to minimise the risks as much as possible through diversification.

Next week we are going to cover some of the benefits and risks of investing in international stocks.

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.

Bonds Q&A

Last week we introduced the basics of bonds, this week we’ll explain some of the features and risks in more detail.

Last week we introduced the basics of bonds, this week we’ll explain some of the features and risks in more detail.

What are the key risks of investing in bonds?

Bonds are less risky than shares, but they do still contain risk.  Below we outline some of the key ones:

Interest Rates

The price of bonds can move around depending on the level of interest rates.  For example, say that you bought the Victorian Government Green bond in 2016 which pays an interest rate of 1.75% p.a.  The cash rate at the time the bonds were issued was 1.75%, meaning you were getting paid the cash rate at the time of purchase.

Fast forward to 2019 and the cash rate is 3.50%, now you own a bond that is paying you 1.75% less than the cash rate.  Investors would rather buy a bond that is paying them the 3.5% current cash rate than one paying them 1.75%.  Because of this, the price of your 1.75% bond has gone down.  At the end of the 5 years, you will still get your $1,000 back, but in the intervening years the price of your bond will move around and you will have missed out on the additional 1.75% return that other investors were able to earn during that period.

Inflation Risk

Because bonds are generally lower risk, they also offer lower returns.  This introduces the possibility that your return may not keep up with inflation.  For example, the interest payment on the Victorian Government Bond of 1.75% is below the average inflation rate of 2.50%, which means that at the end of the 5 year term the purchasing power of your investment will have fallen, introducing the risk that during the term of your investment you may have lost money in real (i.e. inflation-adjusted) terms.

Credit Risk

In buying a bond, you are essentially lending money, leaving you exposed to the credit risk of the borrower.  A bond is a legally binding obligation to repay the debt, however a company (or Government) in bankruptcy may not have the money to repay.  As such, you should be happy with the risk of the company you are buying a bond from.

One of the key ways that people measure credit risk is via a credit rating, you can read more about them here.  The ratings go from AAA (lowest risk of default) to C (highest risk of default).  The higher the risk of default, the higher the interest rate that the bond should pay.  To minimise risk, it is generally best not to invest below a BBB- rating.

The Victorian Government is rated AAA, meaning that there is a low risk of default, which is why the interest rate is so low at 1.75%.  It is worth noting that credit ratings can change, which may impact the price of your bond. If you invest in a AAA rated bond, which is subsequently downgraded (e.g. to AA), then the price of the bond is likely to fall.

Market Risk

Bonds are part of the financial markets and are subject to falls in prices when the bond market declines.  For example, when interest rates begin increasing, the bond market as a whole usually falls due to the inverse relationship between bonds and interest rates.

Bonds are also impacted by the share market.  A study found that in periods of market volatility, the correlation between the bond and share market can get up to 0.50.  This means that if the share market drops by 1%, the bond market could drop by 0.50%.    

What types of bonds are there?

There are a wide variety of different types of bonds that you can invest in, below we have listed some of the most common:

Fixed Rate Bonds: The Victorian Government Green Bond is an example of a fixed rate bond, because the interest rate it pays (1.75%) is fixed at the date of issue and will not move.  Fixed rate bonds expose you to the risk that interest rates will rise.

Floating Rate Bonds:  Floating rate bonds are bonds where the interest rate moves, usually in line with the cash rate.  For example, the Victorian Government could have issued their green bond as paying a floating rate of the cash rate.  This means that the interest rate will increase any time the cash rate increases, and vice versa.  Floating rate notes are a good investment if you think that interest rates will be increasing soon.

Inflation Linked:  It is also possible to purchase inflation linked bonds.  These bonds pay an interest rate that is based on inflation, for example they may pay the Consumer Price Index+0.25%.  The Consumer Price Index is the most common way that inflation is measured.  Inflation-linked bonds are helpful for people on a fixed income, for example in retirement, who need to ensure that their interest payments are at least keeping pace with inflation.

Investment Grade:  Investment grade bonds are those with a credit rating of BBB- or above.  Investment grade bonds are lower risk than non-investment grade bonds.

Junk Bonds:  Non-investment grade bonds (i.e. bonds rated  less than BBB-) are also known as junk bonds.  They are higher risk than investment grade bonds.  If you decide to purchase junk bonds, make sure that you are being compensated for the higher risk by being paid a higher return, and that you are happy with the credit quality of the bond issuer.

That’s it for this week, next week we are going to move on from bonds and discuss the role of shares in your portfolio.

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.