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7 tips for a first-class portfolio

Morningstar staff  |  22 May 2013Text size  Decrease  Increase  |  

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The following article is part of an ongoing educational series. The previous article can be found here.

 

There's no dispute that shares should be a significant part of the investment portfolio of most people seeking solid growth in capital.

After all, over time, shares tend to produce higher returns than investments like bonds and cash. But should they be your only investment? Probably not.

The rationale is tied to practical considerations as well as to the oldest cliché since sliced bread (it features eggs and baskets, if you're wondering).

First practical consideration: most people own or are paying off their own home. It may not feel like it, but that's automatic diversity! So fond are some people of this concept, in fact, they over-invest in residential property, and for some people, it becomes their only substantial investment.

Buying a home has a whole range of benefits that have little to do with money - as well as some that do. For instance, the majority of people who buy a place to live see its value increase over time.

However, unless you pick a bargain property in the country's hottest real-estate market somewhere towards the bottom of the cycle, you're unlikely on average to earn the level of return you can expect from a good share portfolio over long periods of time.

Second practical consideration: everyone needs money to live on now, and for the proverbial rainy day tomorrow. Whether you think of it this way or not, you already have some exposure to cash. Plenty of people also have some capital tied up in term deposits.

It's more than likely, then, that you already have positions in at least two, but quite possibly every one, of the four major asset classes: cash, fixed-interest securities such as bonds, property (your home), and shares.

The problem with having all or too much of your portfolio in any one of these asset classes is that, if one has a terrible year, your whole portfolio has a terrible year. If that one asset class has three terrible years in a row, so does your portfolio. This is known in the business as market risk.

It is also highly likely that after one or two years of poor returns from shares, many investors will instinctively do something to make those returns even poorer (like switch their whole portfolio to cash).

But if you need to free up some money unexpectedly during a low period in markets, you may be forced to sell out of some investments at low prices. The answer to this dilemma, of course, is diversification - spreading your eggs around a number of different baskets.