Designing a portfolio to achieve your goals
You've calculated your required rate of return, now here's how to pick the right mix of assets.
In part one we walked through the process of setting goals and calculating the required rate of return needed to achieve your goals. Part 2 uses that required rate of return as an input into selecting an asset allocation target for your portfolio.
Asset allocation decisions can be a key driver of your portfolio returns and your ability to meet your financial goals. In the first part of this article we discussed the importance of setting a goal and calculating the required rate of return needed to achieve it.
Achieving your goals is the destination of your investing journey. The required rate of return along with saving and investing more money is the way you get there. The first thing that calculating the required rate provides is a view into whether your goal is achievable.
According to Vanguard the S&P/ASX All Ordinaries Accumulation Index has returned 9.4 per cent over the past 30 years. Past returns are not a guarantee of future returns and there are many reasons to think these returns will not be replicated in the future including higher valuation levels. However, historical returns can be used as a sense check for the required rate of return. Any annual return that is in double digits will be very difficult to achieve.
This does not necessarily mean your goal is unachievable. It just means that some changes need to be made. There are two adjustments you can make to your goal:
- You can either delay the date you would like to reach your goal, or reduce the amount of money needed to fund your goal
- You also have the option of saving more
Making any of these adjustments will lower your required rate of return. Once your return requirements are more reasonable you can move on to selecting the type and allocation of assets that will make up your portfolio.
An asset class is a group of securities that have common characteristics that are distinct from other asset classes. These common characteristics refer to the underlying economic drivers of cash flows as well as how the asset is expected to behave in different market environments.
Asset classes are traditionally divided into “income” or “defensive” assets, and “growth” assets. Generally speaking, growth asset classes, such as equities, property and infrastructure, are assumed to achieve higher returns on average than defensive assets. However, growth assets tend to have wider possible variation around that average.
Conversely, defensive asset classes, such as cash and bonds, are assumed to have lower average returns than equities, but with less variation. This variation is volatility and refers to how much the prices of those assets bounce around. As the prices of the underlying assets bounce around the value of your portfolio will change. This can be scary for many new investors, but it is the price you pay for higher returns. For a long-term investor with no need to withdraw money from his or her portfolio for many years this is a trade-off one should happily make.
As the prices of the underlying assets bounce around the value of your portfolio will change. This can be scary for many new investors, but it is the price you pay for higher returns
A portfolio is simply a range of assets that is held by an individual or organisation. These assets can be individual securities such as shares and bonds or professionally run collective investment vehicles such as managed funds, LICs or ETFs. In addition to financial assets an investment portfolio can contain real estate investments, direct investments in businesses, direct loans or even esoteric assets such as investments in wine.
When trying to accomplish a goal, an investor constructs a portfolio made up of different types of asset classes such as cash, bonds and stocks. The question at the heart of portfolio construction is the decision on what asset classes to include and how much of each to include. This process is informed by comparing the risk and return requirements to accomplish the investor’s goal and the risk and return expectations of each asset class.
You have already calculated the return expectations to accomplish your goals which allows you to now focus on risk. At Morningstar, we think about risk differently than most of the financial industry, who use terms such as “price volatility” and “standard deviation”. These measures of risk look at how much the price of an investment will fluctuate. This works well if you are focused on the investment but less well when you are focused on the investor and his or her goals.
Morningstar uses a simpler and more practical definition of risk. We define risk as failing to meet your goals. For investors, that’s the risk of not having enough money in time to retire or having to change your lifestyle so that your savings last throughout retirement. Take some time to think about your own view of risk and how fluctuations in your portfolio would affect your life. If you are investing for the long-term and can adequately cover any short-term cash outlays with an emergency fund, then perhaps your definition of risk is the same as ours.
As an example, consider someone who is saving for retirement in 15 years. This individual has gone through the exercise of calculating a required rate of return and has determined that they need a 3 per cent real return (after inflation) or a 5.6 per cent nominal return (before inflation) to meet their goal. Using this as context, the individual starts thinking about how to construct their portfolio and talks to a friend at a party.
The friend mentions the 3.5 per cent nominal return term deposit she just bought at their local bank and says she couldn’t imagine investing in the stock market because it goes up and down all the time and that is too risky. The friend is looking at volatility as risky since the stock market will fluctuate.
However, listening to the friend’s advice will introduce a new risk—the inability to meet the goal of retirement. To earn the required return, the investor needs to take on the risk of more volatility to earn higher returns. Given the 15-year time horizon until retirement this should be an easy decision.
As part of Morningstar Premium, we offer five different defensive/growth asset class combinations related to five different levels of risk:
You can find them here. The same chart referenced earlier from Vanguard provides historic returns of different asset classes. Keeping in mind that historic returns may not occur again in the future, you can use the chart as reference.
Asset classes v CPI
Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.