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The challenges of building a portfolio from scratch

When I talk with acquaintances these days, the topic of investments naturally comes up. At a kids’ soccer game recently, a parent told me that he’d earned enough money through his business that he wanted to invest it and asked me how to best do it.

I told him that it depended on his goals, risk appetite, and time horizon, and that he should see a financial adviser for professional advice. I then went on to discuss some of his options, but a short way into the conversation, I realized that a five minute talk wouldn’t achieve much. I cut it short and said, “Read Firstlinks and I’ll do an article up on it over the next few weeks”. (no harm in giving the newsletter a plug!)

Here, then, are tips on the best ways to build an investment portfolio from scratch, and some of the challenges involved.

Portfolio theory in a nutshell

First, it’s necessary to cover off on various theories behind building an investment portfolio. I promise to keep it simple.

A central tenet of finance and asset allocation is that risk and return are related. You can’t earn high returns without having large losses along the way. Conversely, you can’t achieve complete safety without condemning yourself to low, long-term returns. Anyone promoting high returns with low risk should be treated with scepticism.

Modern Portfolio Theory (MPT) uses concepts such as correlation, risk, and return to find optimal portfolio weightings. MPT states that owning allocations of different asset classes that don't always move up or down together, is the best way of maximizing returns while minimizing risk and achieving the so-called ‘efficient frontier’.


Source: MCF Capital

Therefore, the key decision facing an investor is the overall percentages of a portfolio allocated to different assets such as stocks and bonds. That decision will determine the risk-return characteristics of a portfolio.

What is the best allocation? There is no such a thing as a perfect portfolio because we don’t know how different assets will perform in future. That’s why diversification is important.

It's often said that diversification is the only free lunch in finance. This quote, usually attributed to the founder of MPT, Harry Markowitz, refers to the power of diversification to reduce risk without necessarily hurting returns.

Markowitz won a Nobel Prize for his theories, yet even he admitted that he didn’t use fancy maths to determine his own asset allocation. In 1952, he said, “my intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

The three drivers of asset allocation

Markowitz wasn’t short of money and minimizing future regret made sense as a goal for him. For others, it may be different.

Markowitz’s comments indicate that investors need to develop a coherent and well-defined personal strategy for the allocation of assets. That strategy, as alluded to earlier, will be driven by three key factors:

Your goals. Financial or otherwise.

Your risk appetite. In my experience, what people say about their tolerance to risk and what they do are completely different things. Often the best way to figure out your risk appetite is to look at how you reacted to past bear markets. Did you panic and sell stocks during the sharp pullbacks of 2022 and Covid? How about during the financial crisis of 2008. Did you panic and sell stocks at the wrong time?

As Fred Schweb colourfully put it in his masterpiece, Where Are The Customers Yachts?:

“There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

Your time horizon. Conventional wisdom suggests that younger people should invest more aggressively than the old. The guideline is based on the notion that younger individuals can afford to take on more investment risk because of their longer time horizons. As investors get older, their time horizons shorten, making an increasing fixed-income allocation more prudent.

It’s the basis of a common rule of thumb used by advisers: that in a stock/bond portfolio, an investor’s bond allocation should be equal to their age, with the remainder in stocks. Under this formula, if you’re 45 years of age, you should have 45% of your portfolio in bonds, and 55% in stocks.

A mix of these factors will determine the best allocation of assets for you.

A simple investment portfolio

For the novice or lazy investor, a simple portfolio can be best. Say you’ve worked out that a 60/40 stock/bond split of assets is what you’re after. The next question: which stocks to choose? If you want simplicity, then the answer is investing in an ETF which covers the whole market.

The stock allocation is not so simple, though. Should you invest just in Australia? That doesn’t make much sense. After all, the Australian share market is only about 2% of the size of global equity markets. The market here is also highly concentrated in banks and miners, and doesn’t offer the exposure to technology, healthcare and other sectors, that international markets do.

Does it mean that you should allocate just 2% of the stock portion of the portfolio to Australian equities? Probably not. There is no right answer because no one knows how different stock markets will perform in future. Keeping it simple might mean a 50/50 split of Australian and international stocks. This split can easily be done via popular ETFs such as Vanguard’s Australian Shares Index ETF (ASX:VAS) and its MSCI Index International Shares ETF (ASX:VGS).

What about bonds? Bonds are in a portfolio because stocks are volatile. It can be gut-wrenching as stocks move up and down, and sometimes people need some money when stocks are down. Bonds are there to smooth out the journey and act as ballast that balances out the stock holdings.

Given this, it makes sense to stick to local bonds rather than branch out to international bonds. Why? Because with the safer portion of your portfolio, you don’t want to be taking the currency risk associated with owning overseas bonds.

As to what type of bonds, government bonds are the least risky and are the most appropriate for a simple portfolio. The most popular Australian government bond ETFs are iShares Core Composite Bond ETF (ASC:IAF), SPDR S&P/ASX Australian Bond Fund ETF (ASX:BOND), and Vanguard Australian Fixed Interest Index ETF (ASX:VAF).

Here is what a basic investment portfolio might look like:

  • 30% Australian stocks (ASX:VAS)
  • 30% International stocks (ASX:VGS)
  • 40% Australian bonds (ASX:IAF)

Getting more fancy

A simple investment portfolio can be made more complex in a variety of ways. Keep in mind that complexity requires more time and effort in both building and maintaining the portfolio.

The stock portion of the portfolio could include small cap companies. US research has shown that small caps have outperformed large caps in America over the long term. Interestingly, the research is less compelling in Australia, as small caps have lagged their larger counterparts. I suspect it’s because of the hundreds of small cap miners here which are both scrappy and unprofitable – and that’s being generous.

Another thing that can be considered for the stock part of the portfolio is adding value stocks. Numerous studies suggest value stocks outperform growth shares and broader indices in the long term.

REITs can also be considered for a small portion of the portfolio. Historically, REITs have shown a lower correlation to other asset classes and therefore can help to reduce overall risk to a portfolio. Keep in mind though that Goodman Group (ASX:GMG) is now around a 42% weighting in the A-REIT index and is priced more like a tech stock and less like a property play. Goodman drives the A-REIT index nowadays.

What about teasing out the international stocks into those of developed countries and emerging markets? It’s certainly an option as different regions tend to offer different returns. Yet, I’m not convinced that it’s worth the trouble for individual investors.

Here’s what a more complicated portfolio could look like:

  • 14% ASX large cap (ASX:VLC)
  • 14% ASX small cap (ASX:VSO)
  • 2% Australian property (ASX:MVA)
  • 14% International large cap (ASX:IOO)
  • 7% International small cap (ASX:VISM)
  • 7% International value (ASX:VLUE)
  • 2% International property (ASX:GLPR)
  • 40% Australian bonds (ASX:IAF)

Getting more hands-on

Now, you might be thinking, “Hang on, I’d like to also invest in stocks directly as well as managed funds.”

On this point, Vanguard Asia Pacific’s Head of Investments, Duncan Burns has an idea, called the core-satellite approach, which may help. This approach is about allocating the core of your portfolio – 80%, for example - to passive investments or ETFs, and the remainder to active funds or an active strategy.

He says that while carving out a small portion of your portfolio for active investing in the satellite portion isn’t backed up by academic studies, it may be helpful behaviourally. It could help you to avoid tinkering with the core of the portfolio and free up the satellite portion to pursue other opportunities – whether that’s an interest in stock picking or sectors or other elements you feel strongly about.

Rebalancing

Rebalancing a portfolio is generally helpful to enhance returns and to reduce risk. Rebalancing is a quasi-value strategy as it means selling something that has been performing well and switching it into something else that has been underperforming.

How often should you rebalance a portfolio? The research says once every year or two is sufficient. However, selling stock attracts capital gains and losses, therefore it will depend on your tax situation too.

Dollar cost averaging

Building a portfolio from scratch also raises the issue of whether you should put all your money into it straight away or to gradually deploy the cash. Some might be nervous putting a lump sum in.

One way to get around this is to put 50% into the portfolio, and then put the other 50% in via monthly increments over a 12-24 month period.

The latter is known as dollar cost averaging and it can also be used for any subsequent savings that you wish to add to the portfolio after it’s up and running. This approach automatically allocates regular fixed amounts and can help you take a disciplined, non-emotional approach to investing that’s not affected by what’s happening on financial markets at any particular point in time.

Remaining pieces

There is no perfect asset allocation that will allow you to keep up when shares are rising and perfectly hedge your portfolio when shares are falling. The best you can hope for is a portfolio that’s durable enough that you can hold onto it, regardless of what happens in the market and economy.

There is a lot I haven’t covered in this article that I’ll flesh out in future pieces. Next week will explore the pros and cons of ‘all weather’ portfolios.

 

James Gruber is the Editor of Firstlinks.

 

41 Comments
Tony
September 13, 2024

The best way to build a portfolio?
Invest in a successful industry superannuation fund, then go to the beach!
Amateur investors and financial planners can’t compete with the wonderful and committed teams who find the best investments all round the world.
Airports, pipelines, property, private equity, shares, all round the world.
What private investor or financial planner on SMSF investor can compete with that?

Industry funds are not the solution for us all.
September 23, 2024

That may suit your goals and I applaud you for finding the solution that suits your psychology.
But I have outperformed the average of Industry funds over the past 9 years with a lower risk and full transparency to my clients. In fact plus 30% total return over that time.
An Industry Fund still relies on a person (Chief Investment Officer) to make the decision, and mistakes will occur. As I have made yet with 30 plus years of knowledge I expect to continue to achieve a positive result, recognizing the ability to take advantage for my individual clients market opportunities.

DavidMC
September 12, 2024

This is a very timely article, - even of you have differing views it stimulates important reflection.
At age 78 yrs I have run my own SMSF for close to 40 years with reasonable results. My current SMSF portfolio share contains 84 shares, ETFs, LIC/Ts, REITs which most will say is too many but suits my methods. I also have a personal portfolio which is less conservative. I also hold managed funds, hybrids and term deposits but no bonds
But my point is that I am among the first of the baby boomers in terms of year of birth, so for the next 17 years all we baby boomers will be moving into our eighties. Thanks to the extreme generosity of the Howard Government, many like me will have accumulated an SMSF in the millions. Like me they will become less interested and less competent in running complex SMSFs and need to decide whether to simplify into ETFs and bonds as James suggests, or rollover the SMSF into a retail fund. Thus your suggested ETF portfolios are very helpful James.
Two points concern me: Firstly there are very large capital gains which will have to be dealt with (Argo, AFI, CBA, NAB, MCQ,WES etc). Perhaps James you could address this?
Secondly, term deposits earning 5% (30% of my SMSF) are reasonable in uncertain times, but if as expected rates drop towards 3% the funds will need to be moved into better performing assets.

James Gruber
September 16, 2024

Hi DavidMC,

I can't give personal advice and I don't know your situation.

Best to get financial advice to get a solution to your particular issues.

Best,
James

Peter Williams
September 11, 2024

I'm surprised that no mention has been made of the Future Fund asset allocation.

I started using it as a starting point many years ago after moving on from trying to pick individual stocks with the greatest upside potential. I had been a SMSF auditor for many years and had seen many variants of asset allocations, most of which had mixed success

In adopting the Future Fund model I chose not to allocate funds to Timber or Real Estate. As a result I have a much higher allocation to local equities which I manage and enjoy doing the research for selections. I try and adopt a 3-5yr time frame for these investments but review the whole portfolio on a monthly basis

For many years I have allocated between 10-15% each to Gold/Silver and Private Equity. These allocations give the portfolio less volatility and help reduce stress during severe equity market swings. The gold/silver bullion holdings also give insurance comfort in the unlikely(?) event of unforeseen geopolitical events

Overseas equity exposure and infrastructure is managed by external fund mangers and split between established and emerging markets

Over many years the above approach has provided more than adequate pensions for my wife and I. I suggest the above be considered for those wishing to be involved in managing their investments

tom taylor
September 10, 2024

Never is a long time frame SMSF Trustee. What you fail to realise is gold is not an investment but rather a hedge. If you'd had 5% in your super fund since 1997 when Costello our liberal treasurer sold two thirds of our reserves (167 tonnes of its gold ) at $US306.00 an ounce. Today it is worth just above $US2,500 so eight times that 1997 figure. If each year you'd rebalanced your SMSF portfolio that tiny 5% not earning anything is a good strategy. Even though there is a small annual cost of a safety deposit deposit box it acts as good ballast in your SMSF.

SMSF Trustee
September 12, 2024

Tom Taylor I don't need any more "ballast" than my cash and bonds give me. I want volatility in my growth assets. And why would I want the bother of having to keep some of my SMSF in a safe deposit box?

Andrew Buchan
September 08, 2024

James - Informative as always - would love your comments RE:
Unlisted Assets? Premium above listed? Diversification benefits?
+
Determinants of Portfolio Performance (1986), Brinson, Hood & Beebower - "asset allocation accounts for 94% the variation in portfolio returns, with market-timing and security selection 6%"

Cheers

James Gruber
September 08, 2024

Hi Andrew,

Thanks for the questions. Unlisted assets - yes, they can provide diversification benefits but my main issue is around transparency with valuations.

On Brinson, most of the subsequent studies have supported the original findings - that asset allocation account for large majority of variation in portfolio returns. I am a believer in SAA.

Best,
James

Kevin Harris
September 08, 2024

I enjoy reading your report. I live in NZ and have bought FANG,VAS, MOAT, QHAL. through ASB securities.
I have just found that I have to pay Foreign investment fund on ETF with overseas investments.I dont understand how this is worked out .
Could you please explain if it is worked out on dividends or capital gains, or what.
Looking forward to your reply. If you were in my situation would yor keep them. Retired 80
Kevin

James Gruber
September 08, 2024

Kevin,

I am not familiar with NZ law on ETF investments. Perhaps another subscriber may know more and be able to comment?

Michael
September 07, 2024

I am puzzled by the 2% real estate allocations. Long term MVA and GLPR have similar performance. REIT has a similar performance. All three have lagged the XRE. XRE is dominated by GMG in size and performance, so wouldn't GMG, as big as the next 6 stocks collectively in the XRE, be more worthwhile in a portfolio. Finally do we need to allocate any dollars in real estate to our portfolios when we are overweight just with our principal residence.

James Gruber
September 07, 2024

Michael,

The reason you can hold REITs in a portfolio is because they're uncorrelated to other assets, reducing risk over the the long-term.

You can hold GMG if you like, but then you would hold a concentrated position in one stock. And at current valuations, GMG leaves little to no room for error.

As for owning a home outside of the portfolio, this article was about an investment portfolio, excluding personal residence.

Best,
James

Matt
September 10, 2024

Hi James,
Great article, I think Michael was asking is there a need to allocate any investment funds to real estate when, as homeowners, we are holding a large portion of real estate outside our portfolio. I suppose it is more diversification when majority of outside RE is residential whilst listed is Commercial.
Is an amount of 2% worth holding, will it make much of a difference. I did read somewhere that you shouldn't have any amount below 5% to make it worthwhile.
Cheers

James Gruber
September 10, 2024

Hi Matt,

If you hold a large portion of real estate outside portfolios, then, yes, it's debatable whether you really need RE inside your portfolios.

As to the small percentages, there are no hard and fast rules of this. It's about what can best deliver risk-adjusted returns for you.

Best,
James

Graham W
September 07, 2024

Where is the allocation to gold bullion and gold stocks? Gold has averaged 8.9 % pa for the last 20 years. There is no counter party risk on bullion and no holding costs or need to pay an advisor a trail fee. I started with gold sovereigns in 1994 at $140 each, now worth $1200 to $1400. What is wrong with a tenfold increase in 30 years?

James Gruber
September 07, 2024

Hi Graham,

Gold can be an allocation in a portfolio. However, over the long term, gold has had returns in line with inflation (over 150yrs, it's retunred 3% pa). Over he past 20 or 30 years, gold has done well, though note it has significantly trailed stock returns. Over the past 30yrs, gold is up 6.1% pa in USD terms, while the S&P500 is up 10.5% pa, and the ASX marginally below that.

I would suggest that gold's role in any portfolio is as insurance, rather than a source of returns.

I will speak more of gold in portfolio next week.

James

SMSF Trustee
September 08, 2024

James has given a perfectly sound response. I would NEVER hold gold in my portfolio because, despite the bleating of gold bugs, it doesn't deliver anything I'd want. Not income nor long term superior returns.
It's just a commodity and I get lots of better exposure to commodities via the resource companies in some parts of my share portfolio. Those who extract gold and earn a leveraged margin on its price are a better asset than physical gold.

CC
September 08, 2024

cash and bonds won't outperform stocks either but have a valid place in a portfolio, just as Gold does.

SMSF Trustee
September 12, 2024

CC gold's volatility means I'd look at it in the bucket for growth assets, so your reference to cash and bonds is, for me, a furphy. As a growth asset gold is a waste of space.

Roger G
September 22, 2024

If you think there will never be a major war or loss of sovereignty then you may ignore gold.

People who live in Ukraine or Kurds etc think differently than Australians in these respects.

Gold miners are subject to many variables like cost inflation, geological issues and government intransigence eg Regent Resources McPhillameys approval debacle. Their resources in the ground are only a benefit of they can extract them at a profit. Bullion or coins in your personal or secured vault possession are truly yours. And the vault can be closed when you want to access it, or holding Gold made illegal like it has been in the past. So in your garden or buried under the house is worthy option for a portion.

Simon
September 07, 2024

Thanks Michael for this excellent article.
Sometimes I think people forget “investment portfolio” allocation to home & mortgage.
Mortgages are Bonds. The value of which should be considered in stock/bond diversification.
Hence, for many under 60 with a mortgage, Super may rebalance toward higher equity %.
The point on asset diversification is key. Not everything can lose at once.

David
September 06, 2024

What sort of return would your first-mentioned portfolio achieved over the past 5 and 10years?

James Gruber
September 10, 2024

Hi David,

The first portfolio would have returned just over 8% over the past decade. If you just stuck with Australian stocks only in your 60/40, it returned 7.8% over 10yrs.

The 5 year returns were lower, at just under 6% for the first portfolio (Covid and 2022 downdraft impacted returns).

David
September 06, 2024

Your "complicated" portfolio looks very much like a simple "balanced" fund from one of our many fund managers who would implement ongoing rebalancing and tweeking. Why not simply accept the fact that an individual cannot implement time and cost effective investing and they should delegate it to one or several competent managers?

PS I do not work for a fund manager

James Gruber
September 06, 2024

Hi David, you can do that. Though note that with a fund manager, you'd pay management fees that are much higher than the passive route mentioned here. So, you'd need to pick managers that can outperform, and that's not always easy to do.

Cheers,
James

Kevin
September 06, 2024

Couldn't disagree more David . An individual investor has it easy,it takes no time at all.That was an advert from mid to late 1990s as the financial industry tried to convince everybody investing is complicated and time consuming.

While I started earlier start CBA and NAB in 1999. $25 each so $50K bought you 1,000 in each of them.Do nothing ,pay no attention as another article says.Use the DRP for 30 years,you'll have around 5 to 6000 shares in each of them by 2030,plus the almost full benefit of the super system, 9% and up from around 2000?

The only time taken is the tax form at the end of the tax year.For two companies that is very simple.

A simple one that I put up years ago. WBC fell to ~ $13 ,I thought it was ~ $12. Buy 1000 at a cost of $13K ( around 2002 )Two thousand would be better @$26 K. Use the DRP for 30 or 40 years and retire comfortably .This takes care of the problem( that doesn't exist ) of females giving birth and being out of the work force.The registry just carries on doing all the work,the female can take dividends for a while to meet loan payments,problem solved.

When I started there was no internet.So I only had people at work telling me constantly,you can't do that.Now the internet is here you've got everybody telling you ( screaming at you ) you can't do that.

While I remember,you bought CBA and NAB at record highs back then.Just in time for the tech wreck slump ~ 3 years later to make or break you, and test mettle.

Cameron Knox
September 06, 2024

The issue with MPT is its recent failures when all asset classes become correlated and fell together.
Without some form of 'Alternatives Allocation" - itself contentious, MPT is perhaps out of date

James Gruber
September 06, 2024

Hi Cameron,

MPT has weaknesses, for sure. As mentioned, there is no optimal allocation, per MPT. Though it can serve as a useful starting point.

I think the correlations issue has been overplayed - correlations flip from positive to negative and back again on a regular basis. 

And I'm not sure alternatives are the answer - colour me a little sceptical on this front.

James

BeenThereB4
September 06, 2024

I am happy with up to 20% in Cash/T Deps/ Hybrids
Balance in leading Listed Investment Companies eg AFIC or Argo ... these transparently give franked dividends.
In SMSF one can look forward to franking credit rebate.

You do not need to invest in foreign securities; you can get exposure through likes of CSL / BHP / RIO / BXB / AMC

munir
September 05, 2024

Hi James,

Thanks for such an intelligible and simple portfolio building article. I am going to invest for the future of my two young kids aged under 5. Any suggestion will be appreciated.
Munir

James Gruber
September 06, 2024

Hi Munir,

As mentioned in the article, conventional wisdom suggests that younger people should invest more aggressively. I think though you've given me the basis for another future article. Shouldn't be too far away.

James

James
September 06, 2024

Food for thought. Look at investment bonds. Depending on your income and marginal tax rate they work well. My daughter and husband are both high income earners on top tax rates and wanted to grow a nest egg for their newborn. As they're a tax paid investment (30%) it won't affect their tax and after 10 years the bond can be cashed out tax free. If you invest in something like VGS then the returns are mostly capital gain. Similarly you can add things like IOO for instance. The kids can be named as the beneficiary if you desire. Check out Australian Unity's website.

James Gruber
September 10, 2024

Thanks James,

Will do.

Jude
September 05, 2024

Found this article very good and would also be interested in a simple portfolio for an older investor, so I don’t lose sleep thinking about it.

Veronik Verkest
September 05, 2024

Great summary. One small typo I think in the basic investment portfolio… VAS rather than VAF

James Gruber
September 06, 2024

Veronik, fixed. Thanks.

Jeff
September 05, 2024

About 30 years ago an Accountant told me of one his very wealthy clients always invested a third in stocks, a third in real estate and a third in cash, with annual rebalance, so I've basically followed this for stress free investing (The Talmud Portfolio ? ) An Indian friend always keeps 20% in cash.

James Gruber
September 05, 2024

Hi Jeff,

Yes, I'll include the Talmud in a piece next week.

Best,
James

Michael
September 05, 2024

Excellent piece. Thanks James. What might a simple portfolio look like for an older investor?

James Gruber
September 05, 2024

Hi Michael,

It's in the works for a future article. Thanks.

James

 

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