Investment portfolio design

When a financial planner designs a personalised investment portfolio for a client, there are a number of important ‘inputs’ which need to be understood and prioritised, for the plan to have the best chance of achieving the desired outcome.

You will note I said best chance. Certainty is not a condition which exists in nature. All successful investing in general, and three decade retirement investing in particular, is an exercise in the practice of rationality under uncertainty. My test of rationality being historical probability. Long term historical asset class returns are generally regarded as an appropriate estimate of long term future asset class returns. However, short term asset class returns of the future may deviate considerably from long term average expectations which is why you will always see the notation “past performance (whether actual or simulated) is not indicative of the future performance” on Investment Policy Statements – this is not a cop out – there is no certainty with investment – only historical probability, and clients fear as an emotion, indeed the controlling emotion for most people cannot simply be ‘overcome’.

Client behaviour is the critical long term investment influence. It is why risk assessment questionnaires have become so fundamental to financial planners with pre plan writing information gathering. Unfortunately, in my opinion too many plans are ‘conservatively’ allocated due to lack of understanding of how asset classes perform over the short and long term versus the findings of a questionnaire which paints by numbers as to whether someone is a conservative investor versus someone who is a growth investor. I’ve found over the years that if someone is truly fearful a ‘conservative’ model portfolio can be just as worrying for a nervous nelly as a ‘growth’ portfolio. Those people are best left – ‘in the bank’ where they can monitor the balance and understand interest rate and term. These people will have either experienced global events such as the depression or world wars or have had parents and grand parents influenced by these historical occurrences. Mutual trust and respect is impossible if fear (of capital loss) is experienced with common and garden market fluctuations (13 since WWII)

After investor behaviour, the next most important decision a planner and investor need to make is – asset allocation. What portion of the regular contributions (or KiwiSaver investor) or lump sum (for retirees with capital to invest – or potential retirees preparing for the eventful day) will go into income investments versus growth investments. Income investments being Bonds (NZ and International fixed interest) and Cash (Money market funds). Growth investments being listed property and equities.

A ‘Morningstar’ model portfolio with a conservative asset allocation could be:

• Cash                                                40%
• NZ fixed interest                             25%
• International fixed interest            20%
• NZ listed property                             5%
• NZ equity                                            2%
• Aust equity                                         2%
• International equity                          6%

A ‘Morningstar’ model portfolio with an aggressive asset allocation could be:

• Cash                                                  11%
• NZ fixed interest                                5%
• International fixed interest               3%
• NZ listed property                              5%
• Aust listed property                           3%
• International listed property            3%
• NZ equity                                          13%
• Aust equity                                        11%
• International equity                         46%

This decision alone (within a well diversified portfolio) will account for 94% of future investment outcomes.

Next week – how do the other ‘inputs’ influence the plan.