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The basics of building a portfolio

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Running your own investment portfolio means you set your investment strategy, select the appropriate asset class mix, and choose the individual investments that will deliver your desired investment outcomes.

Did that statement sound like what you do with your investments?  If it did you are more organised than most, particularly regarding selecting the appropriate asset class mix, or in market speak, ‘asset allocation’.

Asset allocation seeks to create a mix of assets that has the potential to deliver your desired investment objectives, in your specified timeframe, whilst meeting your tolerance for risk.

An asset class is a group of instruments which have similar financial characteristics and behave similarly in the marketplace. Each asset class has different risk and return characteristics.

There are five main asset classes: equities, property, fixed income, alternatives and cash.

nabtrade, and the broader NAB Group, can help you access, and manage these asset classes.
 

Simple capital structure of a company

The above graphic shows you the different ways a company can raise capital to fund their business.  The same graphic also shows the different ways that investors can invest in that company. The company can issue, and the investor can buy: fixed income/bonds (senior and subordinated debt), and/or hybrids or equities.

Once you add property, listed or direct, and some cash, you have the building blocks of an asset allocation model.
 

Strategic asset allocation is determined by your risk profile

Each asset class has a different risk/return profile. As ever, the more risk you are prepared to take on, the higher the potential return.

The most common allocation model is called strategic asset allocation (SAA), which seeks to match your risk profile, investment objectives, and timeframe, with a target asset allocation.

When establishing your risk profile you need to consider two key factors: your ‘ability’ to take on risk and your ‘willingness’ to take on risk. These do not always align. Your ability to take on risk may be governed by your current financial situation, for example someone who has a well-funded retirement account, sufficient emergency savings, additional savings and investments who is debt free has a high ability to take on risk.

However, if this person is retiring tomorrow their ‘willingness’ to put their security at risk would be low. Their risk profile would therefore be low risk and their portfolio asset allocation would reflect this.

Risk profiles can be created in a number of ways, and generally begin with a series of questions.  A sample question is below:     

‘Your portfolio decreases in value by 20% over a 3 month period, what would you do?’

a)     Sell everything and go to cash

b)     Sell part of the portfolio to cash

c)      Monitor the portfolio more closely

d)     Do nothing as the investment is long term

e)     Invest more money in the portfolio

Under a SAA model an investor with a more conservative risk profile would have a suggested allocation with more ‘defensive’ assets like cash and fixed income.  An investor with a more aggressive risk profile would have a larger allocation to ‘growth’ assets like equities or property.  The mix of defensive and growth assets is another way to think of asset allocation.

To maintain the allocation, the portfolio is usually re-balanced annually back to the target allocation.

Typical risk profiles have names like conservative, balanced or growth with the blend of defensive and growth assets weighted appropriately as you would anticipate from these names.
 

Why do it?

Numerous studies have demonstrated that the majority of investment returns are derived from which asset class you are invested in. Type ‘strategic asset allocation’ into Google for this long list. Most of these studies attribute around 90% of return outcome to the Asset Allocation process.  So, if you are long equities when the stock market is running, you will do well, However, the reverse is also true.

In a perfect world, we would all pick the best performing asset class each year, make our investments and then go to lunch.  In the real world we are all trying to balance our need to manage risk, against our desire for investment returns.  No one can predict the best asset class each year, so the solution is to hold a blend of several asset classes to try and achieve the right balance between risk and return.  In this way, asset allocation drives diversification across asset classes, so is also a key risk management tool.

To illustrate, the table below shows the variability of returns across asset classes over time. What this table shows us is each asset class can perform well and poorly through the period under review. For example:                                                   
 

Asset class

Top performer instances

Bottom performer instances

Shares (Australian, International & Smaller Caps):

12

11

Fixed Income (Australian & Fixed Income):

4

4

Property                                  

4

3

 

Source: Morningstar (past performance is not a reliable indicator of future returns)
 

Click here to access a high-resolution version of the image.

The difference between a top performing asset and the bottom performing asset can be as much as 60% return.  This chart therefore shows the importance of holding all asset classes at all times, by weighting your asset class mix to meet your needs you can therefore reduce the risk of significant under or over performance.

This article is a high level introduction to Asset Allocation.  SAA is one strategy that you can use to deliver your investment objectives. By understanding your investment goals and your attitude to risk you can invest in a structured and planned way, increasing your chance of successfully delivering your desired investment outcome.

nabtrade provides tools and insights to allow you to research, and manage your asset allocation.

  • Visit our Investments page to learn more about the asset classes you can access via nabtrade
  • Login to nabtrade and visit the ‘Total Wealth’ section to see a breakdown of your current asset allocation (this is the pie chart next to ‘Total Wealth snapshot’. There is an arrow in the box that allows you to filter your assets by sectors, total holdings and total wealth.
  • Our Insights page provides a variety of education material including videos, podcasts and articles to help you become a better investor.

I hope you found this article informative – good luck with your investing journey.

Craig Saunders is Head of Distribution at NAB Equity Lending. This information has been provided by WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.