Six steps to building a long-term portfolio

When people think about investing, a common starting point is deciding which assets to buy. Perhaps shares for growth, bonds for income, property for both. Although this seems an obvious place to begin, a few earlier steps are required. The first question should be, what are you hoping to achieve? Only with a firm foundation of the reason to invest can a portfolio be built.

In this article, we define six steps to building a portfolio, including a focus on a technique called ‘core-satellite investing’ which is popular with many investors and financial advisers.

Six steps in every financial plan

Regardless of age, financial resources or time horizon, six steps on the investment journey are:

Let’s check each of these in more detail.

First, define your goals

A Millennial saving for a home deposit over a few years has a different investment objective than a Baby Boomer funding a 30-year retirement. Someone needing capital preservation for a deposit in the near term cannot take too much risk in case the major goal is compromised, whereas a multi-decade horizon gives time for recovering a loss.

If a reasonable assessment of likely returns and savings patterns shows a long-term goal cannot be achieved, then it might be necessary to work longer or save more.

Second, decide on your risk tolerance

There is no commonly-accepted definition of risk, although market professionals like to talk about ‘price volatility’ and ‘standard deviation’. These measures of risk look at how much the price of an investment will fluctuate. This works if you are focused on the near-term value of an investment but less well when you are focused long-term goals. In fact, Morningstar defines risk as failing to meet your goals, while others say it is a permanent loss of capital. Either way, for someone saving for retirement, risk is not having enough money later in life, or having to change a lifestyle to avoid running out of money.

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.

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 stocks, most of their return will come from the overall asset allocation between cash, property, bonds, domestic and global shares and other alternatives.

Asset classes are traditionally divided into ‘income’ or ‘defensive’ assets, and ‘growth’ assets.

Generally, growth assets such as equities, property and infrastructure are assumed to achieve higher returns on average than defensive assets, but with a wider range of outcomes around that average. Conversely, defensive assets such as cash and bonds are assumed to have lower average returns than equities but with less variation. As the prices of the underlying assets fluctuate, the value of a portfolio will change. Volatility is the price paid pay for the potential of higher returns. For a long-term investor with no need to withdraw money for many years, this trade-off should be more acceptable than for someone who needs the money in the short run.

When trying to accomplish a goal, an investor constructs a portfolio by deciding which asset classes to include. This process compares risk and return expectations of each asset class.

A broadly diversified portfolio using a variety of asset classes is a good allocation for most people. Depending on risk appetite, Morningstar divides portfolios into five types:

1. Conservative
2. Cautious
3. Balanced
4. Growth
5. Aggressive

Fourth, watch your costs, taxes 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 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: the core/satellite approach

Having chosen a broad asset allocation, the specific investments must be selected. Building an investment portfolio is not an easy task, but the core and satellite method has many fans.

The core, or centre of the portfolio, is allocated to investments that should deliver steady returns, while the satellite portion incorporates smaller investments in specific funds or companies or investments in which you have a strong belief.

A core fund is the main building block around which to construct your satellites. Core funds should be solid performers, often with broad market exposure. They may be low-volatility or passive options that track major market indices, such as index Exchange-Traded Funds (ETFs) based on the S&P/ASX300, S&P500 or Global Bonds, or multi-asset ETFs which provide exposure to a range of asset classes. Index funds are a good way to keep costs down, but investors may also select an actively-managed fund such as a Listed Investment Company (LIC) or Trust (LIT) for the core.

Several active managers offer access to their strategies via the exchange (exchange quoted managed fund or active ETF) like Magellan, Platinum, Fidelity, ActiveX, Pinnacle and Schroders. This takes away the mountain of paperwork required by traditional unlisted managed funds and removes restrictive minimum initial investment requirements. A core fund may have a global mandate to provide diversification or it may have a ‘home bias’.

Satellite funds build on the core to help to strengthen returns. These may be more volatile options, perhaps in riskier or niche areas, making up a smaller proportion of the portfolio. Examples include small cap LICs or ETFs, high-yield and hybrid investments and emerging markets. They may back a view on a commodity such as gold or oil, a sector such as robotics or cybercrime, Australian tech stocks, or the many A-REITs based on property sectors.

It’s likely that the satellite exposure carries higher fees than the broad market index, as the price to pay for potential higher performance.

What happened to the sixth step?

Six, turn down the noise.

Investing should be part of a long-term plan. Turn down the volume on the daily market noise. Investors who jump in and out of stocks and funds incur higher transaction costs and often miss the rally if they sell during a short-term panic. It’s almost impossible to time entry and exit points for better long-term gains than simply enjoying a rising market over time. As Warren Buffett said in 2005, referring to his business partner, Charlie Munger:

"Charlie and I spend no time thinking or talking about what the stock market is going to do, because we don’t know. We are not operating on the basis of any kind of macro forecast about stocks. There’s always a list of reasons why the country will have problems tomorrow.” 

So there it is: choose you goals, understand risk, decide a broad asset mix and select your investments, while keeping costs down and tuning out the daily noise.  

Thanks for the input from Annalisa Esposito and Emma Rapaport from Morningstar. This article is general information and does not consider the circumstances of any investor.

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