Five steps to set your portfolio for the next decade

It seems logical to start an article on investment portfolios by reviewing investments. Sorry to disappoint, but that’s the final step. More important decisions come first.

Here are five steps to build your wealth for decades to come.

1. Define your goals
2. Assess your risk appetite and behaviour
3. Decide your broad asset allocation
4. Examine your costs, tax and administration
5. Choose your investments

Let’s consider each briefly.

First, define your goals

A Millennial saving for a home deposit over five years has a different investment objective than a Baby Boomer funding a 30-year retirement. If a reasonable assessment of likely returns and savings patterns shows a goal cannot be achieved, then it might be necessary to work longer or save more. Each person is different, and a financial adviser can assist in an investment journey.

Second, assess your risk appetite and behaviour

A test of your risk appetite is how well you will sleep at night if your portfolio falls in value. The Australian stock market on average has a 10% fall once every two years, and there have been three falls of over 50% in the last 50 years. Your risk capacity may vary according to:

• Your investment horizon
• Your age and stage of life
• Your knowledge about investing.

Choose a more conservative mix if you are risk averse or older and worry about the value of your investments falling. If you’re under 50, a more aggressive portfolio may be suitable since you have time to invest more and better capacity to ride out the inevitable share market volatility. Perhaps take some financial advice to assist in assessing your risk profile, then leave your money there and don’t be tempted to swap styles.

Third, decide your broad asset allocation

The second-largest fund manager in the world, Vanguard, estimates that 90% of the return from a portfolio comes from the mix of assets in a diversified portfolio, not the share selection. Even if someone has a special talent for picking shares, it matters little ultimately if the overall asset allocation between cash, property, bonds, domestic and global shares and other alternatives is inappropriate.

A broadly-diversified portfolio using a variety of asset classes is a good allocation for the majority of people.

Fourth, examine your costs, tax and administration

While you cannot control the market, you have more influence over the costs you pay. The three major costs to watch are:

• Investment management fees
• Administration fees such the cost of an investment ‘platform’
• Financial advice fees.

You need to decide how you will administer your portfolio. Some people use a simple spreadsheet, and enter their transactions as they buy and sell. The problem with this is the administrative workload, and it does not update automatically. The better alternative is to choose a ‘platform’ or administrative service to monitor your portfolio.

Also, holding investments within superannuation (either a public fund or a self managed super fund) or a company structure will produce a different after-tax outcomes than holding in the name of an individual, depending on the respective tax rates. A financial adviser can assist in deciding the best entity to hold your investments, but superannuation usually delivers tax advantages over the long term.

Fifth, choose your investments

Investing should be part of a multi-decade plan. Turn down the volume on the daily market noise.

Let’s consider how different types of assets have performed in the last decade overall, and in each individual year. As the chart below shows, the years from 2012 to 2017 were good for investors, with positive returns in every asset class. Then shares struggled in 2018 but delivered excellent returns in 2019.

Source: Ashley Owen, Chief Investment Officer, Stanford Brown
 

The surprising aspect of this chart is that compared with other asset classes, Australian shares had a relatively poor decade in the 2010s, with total returns (share price gains plus dividends) of 8% per year. This is below the long-term average of around 11% per year. The 8% was lower than 12% per year from international shares and Australian listed property trusts. Coming in at 6% per year were Australian and international bonds, but with much lower volatility than shares.

The main message from this chart is that returns from different asset classes can be at the top in one year then the bottom in another. In the coming decade, bonds will struggle to match the above returns because most of the gains from falling interest rates have already been made.

Where do share returns actually come from?

Many investors focus on the income from shares or the capital gains, and it is instructive to consider exactly where the returns from shares come from. Drawing on the analysis of Ashley Owen of Stanford brown, he finds Australian share returns come from the following (excluding franking credits):

1.     Dividends contributed 4.1% pa since 1980 and 4.2% pa over the past decade. This is the only component of returns that is likely to be sustainable at similar levels in the next 10 years.

2.     Inflation contributed 3.9% pa since 1980 but only 2.1% over the past decade. Inflation over the next decade will probably average say 2.5%.

3.     Growth in real (ie excluding inflation) earnings (profits) per share contributed only +0.4% pa since 1980 and a negative -1.4% per year for the past decade. This is a poor result, failing to grow real profits per share in the last decade even though the total economic pie in Australia has been increasing in terms of real GDP growth.

4.     Changes in price/earnings ratios are changes in the amount of money investors are willing to pay per dollar of profits. This contributed another +2.5% per year since 1980 and +2.7% per year over the past decade. Price/earnings ratios were 7.5 at the start of 1980, and 15.2 at the start of the last decade, but the ratio is 19.8 now. Investors pay more for the same profits than they did 10 years ago.

Returns likely to be lower in the next decade

On selecting specific investments, a mix of inexpensive index funds, supplemented by active fund managers and some direct shares you like, should perform well over the long term. This applies asset classes such as fixed interest and property as well as shares.

Ashley Owen estimates that if we assume dividends at around 4%, plus inflation of around 2% to 2.5%, plus real earnings per share growth of say 1% or perhaps 2% pa, shares may deliver 7-8% total returns if price earnings ratios remain flat, which is unlikely. If price earnings ratios reduce back to 16, that knocks 2% off returns, to say 5-6% pa on shares.

Investors should follow the five steps outlined above to build a portfolio that matches their goals and risk appetite, but then expect the specific investments within the portfolio to deliver lower returns in the next few years than the last decade. Diversification and managing costs will be even more important in an era of lower returns in these uncertain times.

Graham Hand is Managing Editor of Firstlinks, a newsletter published each week by Morningstar and sponsored by nabtrade. A free subscription for nabtrade clients is available here. This article is general information and does not consider the circumstances of any investor.