Behavioural finance,  Financial planning,  Investing,  Markets

When you build your portfolio start with the big picture

This article appeared in the Australian Financial Review, 22-27 December edition

It would be a pretty unusual artist who starts a portrait by dabbing on the glint in an eye or the blush on a cheek. Like any project, when you construct a portfolio you’re best to start with the big picture and work toward the detail, which means you start with the overall asset allocation.

Asset allocation is the process of working out how much of your portfolio you’re going to invest into different asset classes, like shares, property and bonds, and it’s determined by how much risk you’re prepared to bear in your portfolio and what your overall objectives are, which are two of the most important decisions you’ll make.

Different asset classes can behave differently under the same economic conditions. And even within a single asset class, such as shares, you can expect Australian shares to perform differently to international shares. It’s those differences that provide opportunity.

Vanguard studied the returns of 600 Australian balanced funds over 25 years and found that asset allocation accounted for almost 90% of the risk and return outcomes, with what specific investments you choose and market timing making up the rest. Yet most investors who look after their own portfolio tend to focus the other way around.

The colorful table below ranks the annual returns of nine different asset classes over the past 21 years, so Australian and international shares, bonds, listed property and cash. The trick question is: can you spot the pattern? Of course, it’s a trick because there is no pattern; year to year asset class returns are what’s called a ‘random walk’, in other words, it’s impossible to consistently and accurately forecast which asset class will have the best returns in any given year.

Another striking point is how volatile the returns can be: an asset class that’s top of the pops one-year can be at or close to the bottom the next and the average range of returns in any given year is more than 30%. Also, check out the range of returns within each asset class: for Australian shares it’s more than 50%, for international it’s more than 60% and for US shares it’s more than 80%!

Your asset allocation should reflect your risk profile, and when you’re constructing a portfolio risk is looked at in terms of volatility, or the severity of the ups and downs you are liable to experience. If your entire portfolio is invested in Australian shares but you don’t think you’ve got the stomach for a roller coaster ride that could take you from +30% to -20% or more, then you need to diversify your risk to build in some shock absorbers to your portfolio.

There are a couple of ways to do that. First, you blend ‘growth’ assets (shares and property) with one another, because they can move differently so when they’re combined the overall volatility is reduced. Second, you include some ‘defensive’ assets (fixed income), like bonds, and the ultimate airbag, cash. That way you’ll have something in your portfolio that zigs when the rest zags.

This idea is shown by the grey boxes in the table, which are a blended ‘60/40’ portfolio, meaning it’s 60% growth assets and 40% defensive. You can see the annual returns are in a much tighter range, so while that portfolio will never get bragging rights at the top of the table, importantly, neither will it ever be at the bottom. You’ll have given up just under 2% average annual returns against a portfolio of Australian shares, but you only have to put up with half the volatility.

If you think the returns are a little lower than you’d like and you’re sure you have a higher tolerance for risk in your portfolio, then you can increase the proportion that’s invested in growth assets. ‘High growth’ portfolios can be up to 90% growth assets, but of course with the higher potential return comes much greater volatility.

Over time markets move up and down and so will your asset allocation, which means you’ll need to rebalance from time to time, it’s a good idea to look at it at least once a year. There are two approaches you can take: ‘static’, where you rebalance back to the exact same blend, or ‘dynamic’, where you aim to increase your weighting in those asset classes that offer the best relative value. There are devotees of both approaches and each has its merits.

One great thing about static is it’s much more straightforward. You can use Vanguard’s asset allocation tool to work out the long run average return on growth assets and what combination of defensive assets you need to hit your required returns, keeping in mind you should allow for a 50% pullback in the growth assets to test your risk tolerance. Then you rebalance to that over time.

One of the best arguments in favour of the dynamic approach is that sometimes a particular asset class gets way overvalued. For example, just before the GFC Australian shares and property trusts were historically expensive and it paid off handsomely to reduce exposure.

The hard part about using the dynamic approach is working out the relative value of the different asset classes, which is a seriously specialized job. I’m not aware of any generally available service, so you’ll need to speak to an adviser about that.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

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