Tag: investing

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.

Passive v Active Investing

Investment Style: Passive or Active

Will you follow an active or passive investment style?

The two styles are very different:

 

Active Passive
Belief It is possible to beat the market. It is not possible to consistently beat the market.
Approach Use research and skills to pick the best securities to invest in. Invest in the market.
Fees Charge a higher fee for research and skills. Charge lower fees.

What the data says

The data suggests that the majority of fund managers do not beat the market:

Category Percentage of funds that beat the market over 5 years
Australian Shares 31%
Australian Shares- Mid & Small Cap 29%
International Shares 10%
Australian Bonds 18%

Source: SPIVA Australia Scorecard Mid-Year 2018

The data above is over a 5 year time period.  Over the 10 year and 15 year periods the managers of small-cap stocks (i.e. smaller companies listed on the stock exchange) have been shown to outperform the market.

What does this mean for you?

If you are going to be driven by data, then you would use a passive management style to invest, potentially making an exception for small-cap stocks.

Passive

If you 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%.

Active

You could be the exception to the rule and beat the market.  You have two options to do this:

  • DIY: Do the research and make the investments yourself.

Make sure you have the time and technical skills required for the 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 an active manager – you could 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.

The information on this website is for general information purposes only. It is not intended as  financial or investment advice and should not be construed or relied on as such. Before making any commitment of a financial nature you should seek advice from a qualified financial or investment adviser. No material contained within this website should be construed or relied upon as providing recommendations in relation to any financial product. Balance Impact does not recommend or endorse products and does not receive remuneration based upon investment or other decisions by our email recipients, publications, newsletter or website users.

 

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