Case Study - Retiree - $1 million portfolio
Let us consider a 55 year old with a $1,000,000 investment portfolio. They have recently retired and wish for the portfolio to fund their cost of living in retirement.
Decision 1 - Defensive vs Growth Asset Allocation
The investor wants to immediately start drawing $50,000 a year from their investment portfolio. This is a drawing rate of 5% a year, which should be sustainable in the long term.
Now that they are living off their investment portfolio the investor has said that they are not very comfortable with as much volatility in their portfolio. They feel that they would be able to accept a 20% drop in the value of their portfolio if a 1987 style investment crash were to recur.
The portfolio will also have to act as a cash reserve', and the investor has indicated that they would like to have a further $30,000 invested in cash so that in the event of any unforeseen need this money would be available.
On the basis of this information it would appear that at least $280,000 of the $1,000,000 should be invested in defensive assets. This would allow the payment of 5 years of income at $50,000, with an extra $30,000 available if required. However the reluctance to accept downside beyond 20% of the value of the portfolio suggests that only about 60% of the portfolio should be invested in growth assets.
Let's review this decision against the three key drivers of the decision as to how much of the portfolio to allocate to defensive assets and how much to growth assets.
1/ The timeframe of the portfolio. The timeframe for the portfolio shows that it is starting to be used to fund the investor's living costs immediately. This suggests that a higher portion of the portfolio should be retained in defensive assets. Of course, while the investor is retiring at age 55 they may well still be relying on the portfolio in 35 years time, which will require some of the portfolio to be invested in growth assets.
2/ The liquidity requirements. At least $280,000 should be invested in defensive assets to provide the cash needs for the next 5 years plus a cash reserve of $30,000 to cope with any unexpected financial problems.
3/ The risk tolerance and experience of the investor. They have indicated that they are comfortable with their portfolio falling in value by 20% in the case of a 1987 style stockmarket crash. This implies a maximum growth asset allocation of 60% of the portfolio.
All in all allocating 40% of the portfolio to defensive assets and the remaining 60% growth assets is a reasonable decision.
Decision 2 - Within the Defensive Asset Allocation
40% of the portfolio, or $400,000, is to be invested in defensive assets.
In this case the need for cash can be met by keeping 18 months of income requirements ($75,000) and the $30,000 cash reserve invested in cash. We can round this to $100,000, or 25% of the defensive asset allocation. The remaining $300,000 can be invested in fixed interest securities that will provide a slightly higher expected return. At a practical level we would use a combination of a good cash management trust with the Dimensional Five-Year Diversified Fixed Interest Trust to meet this need.
Decision 3 - Within the Growth Asset Allocation
The first decision that the investor has to make relates to the weighting of Australian shares, international shares and listed property investments within the growth section of their portfolio. In this case the investor was comfortable with the rationale for investing the growth assets:
45% Australian Shares
30% International Shares
25% Listed Property
In this situation the investor has asked that they use a conservative allocation towards value and small companies. After discussions there is agreement to increase the exposure to the index fund and decrease the exposure to small company and value funds.
Within the Australian share portion of their portfolio they have chosen to have 60% of their assets in the index fund, 25% in value companies and 15% in small companies.
Let us again be very clear about 2 factors here - 1/ this asset allocation provides a lower expected return than the asset allocation for investor 1 who had more exposure to small and value companies and 2/ it also decreases the risk (volatility) of the portfolio: taking on less small company and value company exposure decreases both the expected return and expected risk of the portfolio.
Within the international shares portion of their portfolio the theme for less exposure to small companies, value companies and emerging markets results in an asset allocation as follows:
Within the listed property asset allocation the investor was comfortable having 67% exposure through an Australian listed property trust and 33% through international listed property trusts (hedged).
The following table sets up the exposure to each asset class and sub asset class. To work out the exposure for each asset class we start by multiplying the weighting of defensive vs growth by the asset class weighting by the sub asset class weighting. For example, Australian index fund exposure is in the 60% growth allocation multiplied by the 45% Australian share exposure multiplied by the 60% sub asset allocation to the Australian index fund:
87.5% x .45% x .4% = 16.2%.
We round this up to 16% because we don't want the figures to suggest that they are more precise than they really are.