Case Study - Young Investor - Small Capital Base - Regular Savings
Let us consider a 30 year old with $40,000 to invest along with $200 a week of surplus income.
Decision 1 - Defensive vs Growth Asset Allocation
The investor has a long time frame for their portfolio, planning to use it to help fund their retirement at age 55.
They feel that they are comfortable with investment risk and, because they understand that it is a long term investment, they are prepared to accept a fall in value of their assets of around 35% were a 1987 style sharemarket crash to recur.
They have their life insurances and health insurances up to date, so there is little concern that they will need any funds from the portfolio to help meet their cost of living. That said, they also have an adequate cash reserve and mentioned that having a further $5,000 to $10,000 to meet any unexpected costs made sense to them.
On the basis of this information it would appear that the portfolio could be heavily biased toward growth assets. Keeping $5,000, or 12.5% of the portfolio in defensive investments will allow the investor to access this money if there is an unforeseen need for money. If the ongoing contributions of $200 are invested in the same way, with 12.5% in defensive investments, then this $5,000 can be built to $10,000 to provide ready access to cash for the investor.
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 is 25 years, a long timeframe, and is suited to investing in growth assets.
2/ The liquidity requirements. Only $5,000 to $10,000 is required and only for an unexpected event. Allocating 12.5% of the portfolio to defensive assets provides $5,000 if required, plus 12.5% of the ongoing $200 a week portfolio contributions will increase this above the $5,000.
3/ The risk tolerance and experience of the investor. The investor has indicated that they are comfortable with their portfolio falling in value by 35% in the case of a 1987 style stockmarket crash. The 12.5% of the portfolio invested in defensive assets will mean that a 35% fall in the value of growth assets will see the portfolio fall in value by about 30%.
All in all allocating 12.5% of the portfolio to defensive assets and the remainder to growth assets is a reasonable decision.
Decision 2 - Within the Defensive Asset Allocation
The subtle differences between cash and fixed interest investments need to be considered in building the defensive asset allocation. In this case the defensive asset allocation of the portfolio is only providing a pool of funds in the event of some sort of crisis. On that basis, and given that the investor has some other cash outside of this investment portfolio, it is reasonable to invest this money into fixed interest investments - provided that they are high credit quality bonds without unreasonably long time periods to maturity. At a practical level we would use 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
The investor has read about the higher average returns possible from investing in small and value companies. They also accept that these returns are the result of taking on more investment risk. They feel that given their long investment horizon, they would like above average exposure to these sources of additional risk and reward.
After discussion it is agreed that their portfolio will have a significant exposure to value companies and small companies.
Within the Australian share portion of their portfolio they have chosen to have 40% of their assets in the index fund, 35% in value companies and 25% in small companies.
Let us again be very clear about two factors here - 1/ this asset allocation provides a higher expected return and 2/ it also increases the risk of the portfolio: taking on small company and value company exposure increases both the expected return and risk of the portfolio.
Within the international shares portion of their portfolio the theme for more exposure to small companies, value companies and emerging markets results in an asset allocation that sees:
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 table on the next page calculates 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 87.5% growth allocation multiplied by the 45% Australian share exposure multiplied by the 40% sub asset allocation to the Australian index fund:
87.5% x 45% x 40% = 15.75%.