Build the ideal portfolio
Your risk tolerance and goals should determine the appropriate mix of investments
The investment world is full of concepts and jargon. Defensive, growth, correlation, risk, yield … the list goes on. What’s less frequently talked about is how these concepts fit together to form possibly the most important concept of them all – portfolio construction.
As billionaire hedge fund manager Seth Klarman put it, “the challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions”.
How you construct your portfolio will go much further towards achieving your objectives than the individual investments you make. Research by Vanguard has shown that 88% of the investing experience, being volatility and returns, can be attributed to asset allocation.
So how do you go about it?
Set the goals
You don’t start laying the bricks to build a house without first working out a floor plan. The same logic applies when constructing a portfolio.
“You need to know what you’re trying to achieve in the first place, when you’re trying to achieve it, and how you wish to get there,” says Stuart Fechner, director of retail relationships at Bennelong.
It may seem obvious, but goal setting is frequently ignored by many investors.
“Most people don’t really think about goals at all,” says Jonathan Philpot, a partner at HLB Mann Judd. “Ask yourself: what’s the purpose of the portfolio?”
Key elements in a sound plan would include an explicit objective, constraints (such as time), a saving or contribution target, and a timeline for monitoring and re-evaluating progress.
“Goals should be set at different points along the investment time horizon. While long-term investing should require long-term positions, it doesn’t mean you should set and forget,” says Philpot.
Fechner suggests putting shorter-term check points along the way so you know whether you’re on track. “Near-term goals are a bit more tangible and achievable, rather than only having an outcome that’s 20 years down the track.”
Understand your risk appetite
Return can typically be easy to generate by taking on more risk. Conversely, less risk will typically lead to lower but safer returns. Don’t go looking for any free lunches in investment finance.
The amount of risk you take should be informed by your constraints – expenses, income level and, most importantly, your time horizon.
The investment horizon is especially critical. The longer the timeframe, the longer there is to recover from losses and the more risk you can generally take.
“A lot of the return and risk dynamics will be driven by investors’ risk tolerance – the risk they are willing to take and the timeframe through which they’re willing to invest,” says Balaji Gopal, head of product strategy for Vanguard Australia.
“If you have a longer time horizon, it makes sense to invest in higher-growth assets, or a greater portion of the portfolio being weighted towards equities. Conversely, an older investor or retiree who may not have the time to take high levels of risk may weight the portfolio towards fixed income.”
Philpot suggests taking minimal risk within a threeyear investment timeframe, some risk between three to 10 years, and high levels of risk if the investment horizon is longer than 10 years. The last thing you want is to suddenly lose 10% of your savings just when you commission renovations.
Growth versus defensive
Once you’ve settled on the amount of overall risk you’re willing to take, it’s time to manage that risk through the asset allocation. A portfolio’s return and susceptibility to volatility is a function of the split between growth and defensive assets.
“For most investors, it’s better to take a step back and ask how much you want in growth and defensive,” says Justin Tyler, director at Daintree Capital. “From there, you’ve got to think, ‘What is my defensive allocation going to look like?’ ”
In one sense, the growth side of the equation is easier to work out. Growth assets sit at different points along the risk spectrum, but at the end of the day capital appreciation is what they’re all about.
Defensive allocations, on the other hand, provide protection against volatility while also providing income – a duality that can muddy the role of your defensive allocation.
“That’s where a lot of people come unstuck,” says Tyler. “There’s a tension between the desire to earn income and the desire to be defensive.”
Investment-grade bonds form the core of a typical defensive asset allocation, acting as a hedge against volatility while also providing income via regular coupon payments.
But even among bonds, risk profiles can vary. “In fixed income it’s best to think of three key risks: interest rate risk, credit risk and liquidity risk,” says Tyler.
Credit risk is the possibility that providers of debt securities – for instance, government or corporate bonds – will default. This is less of a risk for government bonds, which are deemed the safest place to house your wealth with the exception of cash.
Then there’s liquidity risk – the ease with which you can turn your assets into cash.
“Defensive allocation is where you’ll turn if you want to quickly raise cash,” says Tyler. “On the liquidity side, you run the risk of not being able to pull capital to cash, missing out on opportunities. Then credit risk comes to the fore as you go down the credit spectrum – it becomes more equity like. If investors put deeper thought into the sorts of risks they are taking in these buckets, then a better portfolio can be constructed without changing the 80/20 [growth/defensive] construct too much.”
Finally, there’s interest rate risk. As rates rise bonds will lose their value on the secondary market because investors will favour newly issued bonds with higher coupon payments. This is more pronounced for long-term bonds, which are more sensitive to rate changes.
All of these risks pose different challenges for investors. “If you chase yield in fixed income, you’ll go down the credit spectrum and take liquidity risk,” says Tyler.
“Current yields are off their lows but even from today’s starting point it is difficult to project attractive returns over the medium-term,” according to a white paper from Insight Investment. “A post-Covid-19 recovery could see yields back up a little, but we see limits to this … we argue that government bonds still have an important role to play in a multi-asset context, but it seems clear that their return-generating attraction is greatly diminished.”
Not quite so “balanced”
Many people have their nest eggs invested in “balanced” funds. These funds, as their name implies, purport to balance investment risk in a portfolio.
But don’t let the label deceive you. “Balanced” may be one of the investment industry’s great misnomers.
To the uninitiated, a balanced portfolio would hold roughly half of its exposures in growth assets and the other half in defensive assets.
Yet some so-called “balanced” investment options hold up to 90% of their allocations in growth assets.
“As interest rates have dropped, balanced funds have increased their allocations to growth assets,” says Philpot. “It’s much riskier than what most people would understand a balanced option to be.”
‘ “There’s a tension between the desire to earn income and the desire to be defensive”
Manage the ups and downs
As noted in a paper from CMG Wealth, “many people think that they are diversified simply if they own a lot of different stocks or different mutual funds. However, if all the stocks are technology companies, you aren’t really diversified just because you own a bunch of them. Even owning shares of a dozen mutual funds doesn’t necessarily mean diversification – not if they are all large-cap growth funds.”
Investors should go a step further.
“A good way to manage portfolio risk is to select assets that have little correlation,” says Vanguard’s Gopal. “For instance, equities and government bonds have close to zero correlation.”
Correlation is important across asset classes but also within asset classes.
“You’re going to get different ups and downs between cash assets, government bonds, corporate bonds – they all have different risk profiles and correlations between themselves,” says Fechner.
Even diversifying within the bond allocation brings down the risk. “To capture the defensive characteristics of bonds, it is critical to hold a broadly diversified allocation to high-quality investment-grade bonds across maturities,” a Vanguard white paper explains.
Combining Aussie and international bonds can provide this diversification. “The expected portfolio diversification benefits of bonds increase with the inclusion of globally diversified bond exposures. This is due to the imperfect correlation of interest rates and inflation between Australia and other countries, as well as the diversity of issuers within the global indices.”
Insight Investment notes: “Barring a big rise in inflation or an un-anchoring of inflation expectations, the negative correlation between equities and bonds will probably hold. In that sense, the government bond unicorn has not lost all of its allure and they still have a role in helping to diversify holdings in more risky assets without the negative costs often associated with other hedges.”