Effective portfolio construction is essential to successful investing, but many investors struggle to understand the underlying concepts, much less put them into practice.
Fortunately, constructing an investment portfolio that suits your needs and delivers your goals is simpler than it sounds.
The first step to effective portfolio construction is simply knowing what you want to achieve.
Every portfolio has a purpose. It might be to fund your retirement or to provide an inheritance for the children. It might be to pay for education or housing.
Understanding your purpose and setting a goal for your portfolio lets you plan for how much you need to invest and how long you have for your savings to grow.
Good portfolio goals are measurable, attainable and based on reasonable assumptions. That means they do not require impracticable savings targets, lucky breaks or unlikely investment outcomes.
Take the example of an investor who needs to save $1 million in today's dollars to comfortably retire and has 40 years of working life left to do it.
If that investor makes a $10,000 deposit today and saves the same inflation-adjusted amount every year for the 40 years, the real required rate of return from the portfolio only needs to be an achievable 4 per cent per year.
The portfolio construction process begins with this kind of plan.
From there, the next decision is to select the assets that will deliver the required 4 per cent return without exposing the investor to needless risk.
There are three main asset classes for investors to consider: equities, fixed income and cash.
There is also a wide range of sub-groups like real estate, infrastructure and commodities, but most diversified investors will have exposure to them through the equities asset class.
Asset classes are best understood by the way they typically perform in terms of risk and return.
Equities, or shares in stock market-listed companies, are characterised by demonstrating the highest historical return of the three, but with an associated higher risk of loss.
Fixed income investments like government and corporate bonds tend to provide lower returns but come with lower risk of losing money.
Finally, cash provides both low return and very low risk and protects you from the risk of being forced to sell other assets, but its value is continually eaten away by inflation.
So how do investors balance the three?
The aim is to find a way to deliver enough return to achieve the goal while minimising the risk of permanently losing capital on the way.
This concept of risk is worth exploring. Many investors conflate risk with volatility but for a regular investor with a defined goal, a better definition of risk is the chance of losing money at the very point you need it.
A period of negative returns in the market - as we are likely to see in the coming years - may not be a risk for someone willing to wait until the market recovers, thereby avoiding selling during the downturn.
But if another investor needs the money and has to sell at lower prices, that becomes a permanent loss of capital – the definition of risk.
This risk of permanent loss is why younger people can comfortably take more risk in their investments – and thus aim for a higher return – than someone nearer retirement.
A 35-year-old has at least 30 years of earning income ahead of them, allowing market downturns to run their course. Their income covers their living expenses, so they don't need to withdraw investments at depressed prices, and they even get more assets for every dollar they invest during the downturn. This means they can lean towards equities which offer higher returns at higher risk.
Someone in their 50s has 15 years left of income to recover losses and might choose to take slightly less risk in their investments by reducing their equity holdings.
A retired person has no easy way to add to their investments so if they are forced to withdraw at depressed prices, they suffer permanent loss. In retirement, an even more conservative portfolio might be suitable.
For all investors, constructing a diversified portfolio spread across the three asset classes is the best way to reduce the risk of permanently losing money.
Asset allocation is a surprisingly powerful tool.
Repeated studies show that the vast majority of variability in portfolio returns is explained by asset allocation rather than stock selection or market timing.
So, by simply selecting an asset class mix that suits your risk and return needs - and then buying a widely diversified bundle of investments matching that mix - most of the work of portfolio construction is done with no need to worry about individual investments at all.
Contrast this kind of steady, planned, top-down approach with the bottom-up, investment-collecting approach many investors take.
By buying individual stocks and funds without giving thought to the overall portfolio construction, investors are introducing unnecessary risk to their investments and crimping potential returns.
Portfolios built this way often show concentration in an industry or sector and are prone to being buffeted by volatility and attempts at market timing.
A well-constructed portfolio should also diversify by holding assets across a variety of countries, sectors and industries. Investors may even want to consider a mix of investment styles by holding active managers alongside index funds.
By holding hundreds or thousands of individual securities, the chances of any one of them affecting total returns is minimised.
The next factor to consider is fees. One of the best predictors of the future performance of an investment is the fee it charges. Some find it surprising, but the cheaper the fee, the better the performance. This is because the less you pay in costs, the more of an investment's return you get to keep.
Minimising costs is a crucial part of portfolio construction.
And finally, once the portfolio is in place, the critical trick is to stay the course.
Too many investors have been provoked by market swings to buy and sell at the wrong time, driven by fear or impulse.
A disciplined, long-term approach – rebalancing from time to time to stay within a chosen asset allocation and adjusting the risk profile as you age - gives you the best chance of achieving your goal.
Head of Corporate Affairs at Vanguard
BEc (Acc), MBA, CPA, FFin
David has been in the Financial Services Industry for nearly 30 years. He was one of the founding Directors of the successful Financial Planning and Stockbroking Practice, Henderson Gregory Forrest, for a decade. Prior to that, he held senior roles in companies such as ING, KPMG Accountants and AMP. David was previously Chairman of OAMPS Superannuation Trustee Board and currently serves as an independent Board Director for several companies.
David’s extensive experience in all forms of superannuation, including Self Managed Super Funds (SMSF), Defined Benefit Funds, retirement funding through Account Based Pensions, stockbroking with a focus on Direct Share Investment, Taxation/Remuneration Planning, Centrelink, Aged Care and business management, equip him to advise expertly on all aspects of Financial Advice.
Those with a particular interest in superannuation/SMSFs, direct share investment, salary packaging or applying for the Centrelink Pension will find his knowledge and ability in formulating and implementing creative, logical and simple wealth creation strategies a valuable asset.
David maintains a strong personalised client service focus, providing tailored solutions for clients.
David Forrest is an Authorised Representative of Integrity Financial (SA) Pty Ltd ABN 16 133 921 187 — AFSL No 334846
Business Finance Manager
B Bus (Acc), CPA
Michelle’s career has spanned across the Financial Services, Retirement Living and Aged Care industries working in the private sector, not for profit and more recently with the state government for over 20 years. Her experience extends to many facets of the financial services industry, having worked in superannuation administration, technical support and financial planning practice administration.
Commencing with AMP and subsequently working in commerce and accounting roles with companies such as Brambles, Adelaide Bank Retirement Services, ECH Inc and SA Health and Wellbeing, Michelle returns to financial services after working in practice financial management at Henderson Gregory Forrest. This wide range of experience from senior accounting and management roles has provided Michelle with a strong background in business administration.
With an astute financial acumen and keen interest in business improvement strategies, Michelle ensures the smooth running of the Integrity Financial Advisory practice providing valued management support to our personalised client service focus.
B Com, Dip FP
Darren joins the Integrity team as a strong technical specialist with almost 20 years’ in the Financial Services industry. He has extensive experience advising clients on how to build and protect wealth, prepare for retirement and retire comfortably.
Commencing with advising clients on direct equities for over 10 years at Baker Young, Tolhurst Noall, and ABN AMRO Morgans, his career expanded to providing holistic client advice, having operated his own financial services licence and company. Most recently having worked for a 'Big 4' bank, he has welcomed the more personalised ‘client first’ approach that is evident at Integrity Financial Advisory.
With a deep understanding of investment markets, he is appropriately qualified and authorised to provide direct share advice, as well as superannuation/SMSF advice, encompassing both investments and insurance.
Meticulous in his approach, he aims to deliver quality outcomes for clients by understanding their financial situation and needs before providing advice which is central to our advice process. Darren supports David in tailoring solutions for all client financial advice needs.
Darren Chalk is an Authorised Representative of Integrity Financial (SA) Pty Ltd ABN 16 133 921 187 — AFSL No 334846
Client Service Manager
Natasha commenced working in the financial services industry in June 2008 and is a new addition to the Integrity team. During the past 11 years, she worked closely with advisers providing administration support in a share broking and financial advice business.
Having successfully completed her RG146 accreditation in securities and managed investments and continued her studies to complete her competency in Superannuation, Natasha can ably assist with all aspects of fixed interest, cash management, portfolio administration, direct shares and client advice implementation.
Natasha takes time to ensure she understands our client’s financial goals and needs and believes in creating, preserving and utilising wealth through effective financial management as a key objective in helping clients.
Client Service Manager
Kelly has worked in the Financial Services Industry for over 10 years and has supported David since 2013. Kelly’s primary background is in customer service and administration.
On starting in the industry, Kelly initially focused on direct shares, stockbroking administration and client liaison. Since moving to the Client Service Manager role, Kelly has developed skills encompassing all aspects of financial planning including client advice implementation and term deposit management.
Kelly’s experience in the direct share environment, especially management of estates, provides a key part of the direct equity expertise in Integrity’s Client Service Team.
Returning from Parental Leave following the arrival of her second child, Kelly has developed further honed multi-tasking skills after juggling the demands of a growing family.
Client Service Manager
Jasmine has worked in the financial services industry for over 12 years in all areas of client administration, working with David since 2013.
Jasmine has extensive knowledge and experience in client service including implementation of advice, portfolio reporting, assisting with the establishment of Self Managed Super Funds (SMSFs), term deposit management and a long history of helping clients with their enquiries.
Jasmine’s attention to detail, yet gentle approach, means she is able to solve the trickiest of questions for our client community.
Jasmine has gained her Certificate III in Financial Services qualification.
Client Service Manager
Merrilyn has worked in the financial services industry for over 11 years in all areas of client administration, and is a new addition to our client services team, returning from Melbourne to join the team in June 2019.
Merrilyn has extensive knowledge and experience in client service including implementation of advice, managed fund administration, assisting with the establishment of Self Managed Super Funds (SMSFs) and process improvement for the previous practices she has worked with. Merrilyn’s experience with direct shares constitutes the other part of our administrative support for direct equity investments.
Merrilyn’s warm and caring nature continues to endear her to our clients and she has already established herself as a valued member of our team.