June 27, 2024

How to construct an investment portfolio

We examine the building blocks needed to construct an investment portfolio, and the options available to expand your investment universe.

construct an investment portfolio

The types of investments and the amount held are important considerations when you first construct an investment portfolio, as is a sound understanding of your risk appetite.

Most people know options like an interest-bearing cash account or term deposit. While these offer a safe return on investment, they generally offer a return that is close to the prevailing inflation rate.

This means savings growth is low relative to increases in the cost of living.

The cash rate matters

Central banks set the cash rate based on current and expected inflation changes, which directly affects the returns on cash and other investments.

This low rate of real return is why many investors turn to alternative assets to boost their returns.

Investors branching out and seeking to construct an investment portfolio, typically keep enough aside in a cash account or term deposit for any short-term needs (less than 12 months).

For anything longer, there are several asset classes to consider, each with their own ideal time frames and depending on an investor’s expectation for return vs risk.

Low volatility assets such as floating rate notes may be used for funds potentially needed in the shorter term, while funds available for longer term investments may go to assets like shares. The latter would be expected to experience higher volatility but also offer the potential for better long term returns.

Shorter term investments

Floating rate notes are relatively low in volatility and work by offering a margin above the expected cash rate. The risk of loss on capital is subject to the issuer of the bond remaining solvent, which is why corporations with strong credit ratings (For example, the Australian big four banks) are often selected.

The margin above the benchmark rate can vary between 50bps to 400bps, depending on the issuer and the tier of debt chosen. For example, a floating note that offers 200bps (2%) above the benchmark rate today of 4.35%)[1] would pay the investor a 6.35%pa return.

Investors normally use these for funds that may be needed over the next 1 to 5 years.

Fixed rate bonds are also considered to be relatively low in volatility, however, in addition to credit risk they also carry interest rate risk. These bonds are issued at 100 when the bond is first issued and are redeemed at 100 on the maturity date (assuming no default), which is typically 5 to 10 years from the issuance date.

It means if the bond is held to maturity the investor will receive their initial investment back in full, in addition to interest earned.

However, sometimes investors may identify another opportunity or need access to capital before the bond matures. In this case, investors may sell the bond at the prevailing market price before maturity.

Also worth noting is how interest rates impact bond prices.

If interest rates move lower, existing bond prices moves up. This is because as rates fall, new issuances generally offer a lower yield, making bonds issued when rates were higher more attractive.

The reverse is also true, if interest rates move up, the bond price moves lower.

Which bond to choose?

Fixed rate bonds usually pay a return similar to floating bonds, but the key difference is that the coupon is fixed, meaning they are normally preferred if an investor feels that interest rates are likely to move lower over coming years.

Investors typically use these for funds needed in the next 5 to 10 years. High quality bonds in June 2024 were paying around 6%pa.

Longer term investments

Equities (stocks) are considered to be one of the most volatile asset classes over the short term but potentially offer a relatively higher return over the long term.

Historically, they have outperformed other assets, including property.

For funds that can be put aside for longer time horizons, investors can consider equities, as well as tools such as margin loans that allow investors to borrow and invest in equities, just like many people do with property.

This is because a longer time frame allows investors to weather market downturn and capitalise on long term growth potential.

When you construct an investment portfolio, investors should also consider their comfort with market swings and the ability to remain invested during turbulent times.

Commodities, such as gold or oil, can be a hedge against inflation and a diversifier in a portfolio. They tend to be uncorrelated to stocks and bonds. Investors can gain access to commodities and miners through several listed exchange traded funds. Investors may consider these assets to reduce overall portfolio volatility during periods of higher inflation.

Property is a very popular long term investment vehicle, normally held for over 10 years. However, investors need to consider the costs involved to buy and sell a property is a lot higher than shares given expenses like agent costs and stamp duty, as well as ongoing maintenance costs.

It should noted property can go through long periods of flat prices, but over the long term have created wealth for many investors. However, as an asset class, it has historically underperformed equities.

According to Bloomberg, over the past 40 years Australian property has returned an average annual return of 8.8%pa compared to Australian equities at 10.3%pa and US equities 12.1%pa.

Diversification matters

When choosing asset classes to construct an investment portfolio, keep in mind a well-diversified portfolio that considers the weighting of each asset are key components.

This is because by holding more uncorrelated assets, portfolio volatility decreases. This can help improve the overall portfolio return.

While holding as many uncorrelated investments as possible is generally a good idea, investors also need to consider their own risk tolerance and investment time horizons when making investment decisions.

 

Long term returns

As of April 2024, $10k invested in 1984 is now worth:

Asset class       Todays value    Average return (pa)

Cash:                    $120,727            6.4%

Bonds                   $206,579            7.9%

AU property       $296,283            8.8%

ASX200                $498,757            10.3%

S&P500               $962,560            12.1%

*ASX200 and S&P500 represent AU and US share respectively. Source Bloomberg as of April 2024  – The annual return shown is the effective annual compound rate of return. Past performance is not a reliable indicator or guarantee of future performance.

Exposure can be gained to either of these indices through an exchange traded fund utilising the nabtrade trading platform.

[1] Source: Bloomberg as at April 2024

 

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