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 & Cash

Everyone knows what cash is, but do you know how to get the best return for your cash, or why you should have it in your portfolio?

Everyone knows what cash is, but do you know how to get the best return for your cash, or why you should have it in your portfolio? This week we cover the basics of cash as an asset class.

Why hold cash in your portfolio?

The key reasons that people keep cash in their investment portfolio are to:

Minimise risk:   Cash is the ultimate risk free asset.  The government provides a guarantee of up to $250,000 for any deposits held with an authorised bank, credit union or building society.  This means that if a bank goes bankrupt, the Federal Government will make sure that you get your deposit back, up to a maximum amount of $250,000.  Keeping some amount in cash helps reduce the total risk of your investment portfolio.

Liquidity:  Liquidity is a financial term referring to how quickly an asset can be converted to cash.  Shares in large, well-known companies are very liquid because you can sell them immediately on the stock-exchange and have the cash in a few days.  Your house is less liquid, as it would take a minimum of a few months before any proceeds from a sale would arrive in your bank account.  Cash is the most liquid asset.

Having access to some cash is important, it gives you the flexibility of being able to access money without being forced to sell your assets in an unfavourable market.  For example, if you plan to spend $10,000 on a holiday this year, then it is best to keep that amount in cash.  Otherwise the $10,000 you saved up and invested in shares, might be worth only $6,000 by the time you are ready for your holiday, if you have to sell in an unfavourable market.

It is important to have enough cash on hand to meet your short term expenses.Generally if you think you’ll need to access the money anytime in the next three years then it is best to keep the money in cash.

Opportunistic:  If you can’t find a suitable investment opportunity, then it may be worth keeping your money in cash until you do.  Then, when a suitable opportunity arises you will be ready to go. 

Where to hold it?

Cash, like any other investment, needs to earn a return.  The return will depend greatly on where you hold it.  Your options are:

Standard Bank Account:  This is the lazy option, and you’ll pay for it by way of abysmal returns.  Most standard bank accounts pay interest of close to 0%.

High Interest Saving Account:  This is a better option, particularly for money that you don’t need to access day-to-day, as these kind of accounts generally have limited accessibility (e.g.no ATMs).  Many providers offer high introductory rates (currently around 3%).  If you do take advantage of an introductory rate, make a diary note 2-3 weeks prior to the end of the introductory rate so that you can shop around for another introductory rate.

Term Deposit:  A term deposit is money that you deposit with a financial institution for a particular length of time, anywhere from 1 month to 5 years.  The benefit is that term deposits usually pay a higher rate (currently between 2% – 3%) than leaving your money in a standard bank account.  The downside is that if you need to access the money before the end of the term, you will forfeit some or all of the interest.

Exchange Traded Funds:  It is possible to invest in cash via an exchange traded fund (“ETF”).  This means that you can purchase the cash ETF on the stock exchange (the same way you would a share) and get access to a number of term deposits.  The upside is that someone else is managing your cash with the goal of maximising the interest rate.  The downside is that you will pay a fee for this management.

Cash Management Fund:  It is also possible to invest in a cash fund managed by professionals to maximise the return from your cash.  Like all funds, you will pay a fee for this service.

Too much cash?

If you are a worrier, you might be tempted to hold all your assets in cash, given the low risk.   However, it is possible to hold too much cash in your portfolio.  Cash is very low risk, and consequently the return is also low.  The bare minimum investment return that you should expect from your portfolio is inflation.  The reason that $100 is worth more today than in 10 years’ time is due to inflation. 

If you are earning less than inflation, then the purchasing power of your money is slowly being eroded.  Over the last 20 years inflation has averaged 2.5% per year, this means that you should aim to earn at least 2.50% p.a. on your portfolio.  This is not always possible with cash, as such, some of your investments should be held in other assets.

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.