Variety is the spice of the life, so the saying goes, and the same goes with your finances with experts recommending investors hold a variety of assets in their portfolios to avoid ‘holding all their eggs in one basket’.
Holding too many equities leaves you at risk of sharp losses while holding too much fixed income could be too cautious and mean you miss out of equity gains, with the ASX 200 already up 23 per cent in 2019. The solution is to hold a broad range of equities, fixed income, cash and alternative assets such as property or alternative funds.
In simple terms, according to Clime portfolio manager Vincent Chen, investors should work by the ‘rule of 100’ which describes how investors should deduct their age from 100 and invest that amount in growth assets and the remainder in defensive assets.
So a 30-year-old with many years until retirement should invest 70 per cent in growth assets and 30 per cent in defensive while a 60-year-old due to retire soon should only hold 40 per cent in growth and 60 per cent in defensive as they have fewer years to make back any losses and will need the income sooner.
As a first step, a financial planner will usually conduct a risk-profiling questionnaire with a client which works out a client’s risk tolerance (how emotionally comfortable a client is with taking financial risk), the risk required (how much risk is needed for the client to reach their financial goals) and the client’s risk capacity (how much financial risk they can afford to take). These questions will cover factors such as age, existing assets, expected retirement date, future earnings and financial outgoings.
If a client expresses a desire for the highest possible returns and are willing to accept large swings in the value of their portfolio then they would be a risk-seeking client. On the other hand, a cautious client may be fearful of risky investments and unwilling to regularly turnover their portfolio.
A global survey by Natixis Investment Managers found 41 per cent of investors said they were unprepared to handle market challenges and 77 per cent would take safety over out performance if forced to choose. At the same time, 86 per cent said long-term gains were most important to them, a ‘fundamental disconnect’ with the need for safety.
It also found two-thirds of investors said they were prepared for market risk at the start of 2018 but with the benefit of hindsight, only 59 per cent said they were actually prepared for the downturn at the end of the year.
“Investors don’t seem to grasp that if they are looking for double-digit returns, they need to invest at the higher end of the risk spectrum. The fundamental disconnect between their expectations about return and their ability to tolerate risk highlights how important it is for investors with their advisers to better understand risk and volatility,” said Damon Hambly, chief executive, Australia, at Natixis Investment Managers.
According to the CFA Institute, there are four types of investors; cautious and methodical ones who have a low willingness to take risk and spontaneous and individualists who have a high willingness to take risk.
Paul Resnik, co-founder of risk profiler FinaMetrica, said: “We score people between zero and 100 and then tell them how that compares to others and how people of a similar score to them invest their money.
“We suggest people re-test their risk profile every two to three years or after a major life event, we find your risk tolerance tends not to change but your financial needs will do over time.”
The next step for the advisers will be to use this information to build a portfolio suitable for their risk levels which could include managed funds, direct equities, bonds, property, cash, ETFs and alternatives.
Or in the words of GSFM adviser Stephen Miller, when it comes to portfolio construction, ‘the first rule of finance is diversification, so is the second and so is the third’.
As shown with the risk tolerances, it is impossible to define the ‘correct’ portfolio as each persons’ needs will vary so firms will usually use a range of five or six different risk levels.
While these definitions vary by firm, most will tend to work along the lines of conservative, moderate, balanced, growth, aggressive and highly aggressive. For example, the lowest-risk conservative one will hold around 85 per cent in defensive assets and 15 per cent in growth while the highest-risk highly aggressive one will hold zero in defensive and 100 per cent in growth assets.
FinaMetrica scores are mapped with the model portfolios of large asset managers such as HSBC, Vanguard and Zurich. For example, at Vanguard, a client with a FinaMetrica score of between 41-53 would be suitable for a Vanguard LifeStrategy 40% Equity fund.
Stuart Fechner, account director of research relationships at Bennelong Funds Management, said: “I’m a big fan of funds for purpose, it’s not about the number of funds but the differentiation between them. You need different roles for different purposes depending on how the market unfolds. It’s about how all the funds work together in a portfolio”.
Equities, either directly via stocks or via equity funds, can bring capital appreciation, dividend income and a potential hedge against inflation. Bonds then bring income generation, capital preservation and hedge against an economic slowdown.
The expectation is that when equities fall, bonds will rise which will offset equity losses and smooth returns. However, since the global financial crisis, this idea has become increasingly ineffective thanks to monetary policy and the effect of the financial crisis on investor sentiment.
Tim Sparks, head of sales and marketing at Bell Direct, said Australian investors tended to have a home bias with their equity investments and it would be worth them including international equities as well to get exposure to areas such as IT and pharmaceuticals which were less covered in Australia.
“Previously, getting access to international markets has been difficult, there have been tax incentives to invest in domestic stocks and investors have familiarity with domestic stocks such as Woolworths. But that barrier has been coming down over time as global brands come into the market which has driven increased demand for international stocks,” he said.
The next step would be considering assets which are uncorrelated with other sources and for that reason, many advisers will then add alternatives to a portfolio.
Philippe Jordan, president of CFM International, said: “A portfolio filled with positively correlated assets will generally not perform as well as a diversified portfolio which contains de-correlated assets – because if all assets fall at the same time, overall losses will be greater.”
The aforementioned Natixis survey found 57 per cent of global investors were looking at alternative investments to enhance the diversification of their portfolio and 65 per cent said they wanted strategies less tied to the market. However, there was significant less awareness of alternatives compared to other asset classes with 15 per cent unsure if they held them in their portfolio.
There is also a difference between alternative assets such as property and commodities and alternative strategies such as market neutral funds and long/short funds which use multiple strategies to create a product with low correlation to equity and bonds.
According to Fechner, an alternative should provide diversification that is uncorrelated with other core portfolio exposures. They are usually held for one of three reasons; to provide downside protection, to offer a consistent return or to counter negative equity markets.
Unlike other assets, the focus of alternative performance is on achieving better risk-adjusted returns rather than best absolute returns. Neither is it the aim for alternatives to improve their performance each month, often they will be flat or under perform the stock market as the expectation is they will provide steady returns in all types of market environments rather than fluctuate like equities.
“It’s important to remember that the investment isn’t happening in isolation, but rather is part of an overall portfolio. Therefore how it correlates and interacts with other assets is paramount.
“Diversification is a key aspect of structuring a robust investment portfolio, but it’s more than a numbers game. Adding more investments that perform or correlate highly with an existing asset isn’t adding true diversification – it’s not improving the portfolio’s risk/return outcome,” he noted.
Jordan said: “Alternative strategies are most effective when used over the long term. Like any investment strategy they will over – as well as under perform in the short term – but the important thing is that over the long-term they provide diversification benefits which smooth returns and help keep investors invested.”
Once the portfolio is in place, the ideal scenario would be to leave it to accumulate, investors are regularly criticised for being too ‘hands-on’ and making changes too frequently on the basis of short-term market movements.
Behavioural finance dictates few people are ‘perfectly rational’ and will make mistakes on the basis of emotional or cognitive biases, such as presuming a stock will perform based on past performance, holding riskier investments in the belief they will outperform safer ones or holding onto a falling stock until they break even rather than suffer a loss.
But life and markets aren’t always that simple and many factors will require the portfolio to be rebalanced. Other times life circumstances such as a wedding, divorce, new baby or retirement will dictate the need for a change to a person’s plan.
Jordan said: “We know that investors are more likely to change allocations during times of market upheaval or change – but this is often the time when remaining invested and sticking to a rational strategy is the best course of action – and changing is potentially the worst.
“Having said that, an investor’s investment horizon is important here as well. If you have a long investment horizon you are likely to get the best outcome by keeping everything constant – and even with a shorter horizon, moving allocations too frequently is rarely a successful strategy. Lots of investors believe that they are good at timing the market, but the reality is that virtually no one is. Sticking with a rational strategy will yield better results.”
In the scenario of a nervous client who wanted to exit their holdings after experiencing market volatility, Fechner said, advisers had two options for how to deal with this.
“You can either use it as an opportunity for client education and a buying opportunity or the client may say they no longer feel comfortable with that level of risk and it is out of whack in which case it may need to be re-jigged.It’s about whether they can sleep at night.”
Life circumstances were not the only reason to rebalance portfolios, they should also be assessed in light of market conditions. With rising stock markets in Australia and two interest rate cuts, GSFM’s Miller said he would be considering changing his allocation now before any major fall.
“People are happy with equity and bond returns right now and that’s when you should be diversified because the party won’t last forever and there are only needs to be one uncertainty to manifest itself and we could need to rapidly rethink the investment environment.
“Indexes have done so well recently that people aren’t as focused on diversification as they should be.”
However, Sparks highlighted it is not in investors’ favour to rebalance too regularly due to transactions costs. These are charged on a per transaction basis or as a percentage of the gross value of the transaction order.
“It takes a disciplined investor in a balanced portfolio to see the short-term market movements and take money out of bonds and into equities. Investors should review annually, the opportunity is there to do so more often but transactions costs build up, even though the costs of buying and selling are much less than 10 years ago.
“Investors shouldn’t be distracted by market noise, should be measured, should understand volatility exists and rebalance on an annual basis.”