Investment Portfolio Design – Part two

If an investment portfolio is premised on a three decade retirement then the retention of purchasing power is important because expenses will double which means the cost of living inflates dramatically for retirees.

If an investment portfolio is premised on a three decade retirement, the retention of purchasing power important and the maintenance of capital is expected, because the investors would like to pass on their wealth to the next generation, asset allocation will definitely be a major decision on how the portfolio is designed.

But a number of questions and compromises are necessary as the overall plan is formulated and each of those key inputs must be prioritised from the start. The better the planning at the start the more likely the plans outcome will match client expectation and enable peace of mind through 30 years of market volatility and client trials and tribulation as they pass through their 60’s and 70’s and 80’s.

So what are the critical inputs?

• What’s the ‘retirement’ income goal, why and how has that been determined?
• What is the duration?  (how long do you expect to live?)
• Is capital to be passed on to the next generation?  (do we need to maintain the whole investment sum, only part of or none – the money runs out when you do)
• What assets are available a) to be invested b) to be cashed up c) partly cashed up?
• Where will the ‘retirees’ reside – short and long term?
• Do we take cognisance of any pensions or alternative incomes (property for example)
• What additional accumulation is possible pre and post ‘retirement’?
• What additional capital may be required through retirement – maintenance, cars, services, healthcare, family, travel (outside budgeted expenditure)?
• What is the investor’s appetite to accept or handle market financial volatility – the constant re pricing of assets due to normal fluctuations or more severe 5 year recessions?
• When does draw down commence (what age)?
• What current situations need to be considered, business, ownership of assets, family, age differences, and health?

The construction of an investment portfolio therefore is complex. It is not something I will contemplate without an acceptance by the investor of the need for a full financial plan. It may be many years before an investor is due to retire and it certainly will be many years that an investor will  spend in retirement – getting it as right as possible in an uncertain financial and human nature environment takes time. Sometimes many hours of time and much analysis.  Based on quantification and qualitative questioning.

Assuming the pre plan analysis is complete, goals and aspirations are understood and future estate management requirements complete – the financial planner can now construct an investment portfolio. But now the life boat drills must begin because for many investors and even accumulators this is completely new territory. (As an aside the next financial recession will be ‘a moment of truth’ for many KiwiSaver accumulators who have only known and experienced phenomenal growth in their ‘Balanced’ ‘Growth’ and ‘Aggressive’ funds since inception due to timing – post GFC. Lump sum investors on the other hand who initiated their strategy at the beginning of 2008 were subject to extreme volatility fatigue as they watched balances decline by 30% to 40%. Both are smiling now, however the experience is harsh without a guiding captain – hence the ‘life boat drills’ analogy).

In last weeks article I outlined an example of two ‘model’ portfolios. One a conservative asset allocation, the other aggressive. Whilst it is not rocket science to understand the four major asset classes and their historical performance what is extremely unusual is out performance – where a professional fund manager consistently outperforms the market in a particular asset type. The public has been led to believe over the years by financial journalists, research houses and fund managers themselves that analysis and expertise of security selection and the timing of sale and purchase will add value and that some analysts will get it more often right than others and therefore deserve star awards and media recognition. I’m more convinced now than ever in my career that the additional cost involved in selecting an active funds management strategy versus using an asset class style (passive/engineered/index type) is not warranted.

Every financial and investment planner is likely to have their own biases and beliefs just as every client is likely to want different things from their relationship with a planner. In my opinion however some things need to be irrefutable – starting with mutual trust and respect, when and if that comes into question it is probably time for the relationship to go their separate ways.

In my life boats drills analogy I focus to education and advice on;

•  Trust
•  Patience
• Discipline

They are the three principles of investment. – then;

• Asset Allocation
• Review
• Re-Balance

The three practices of investment.

These principles and practices cover a multitude of client misunderstanding and misinformation. Who and How you choose to invest follow.

• Paying for advice versus DIY
• ‘Active’ funds management versus ‘Passive’ funds management
• Planning versus product purchase

These are the three people decisions. – then;

• Cash management (control)
• Investment (portfolio)
• Risk management (insurance, Wills and Trusts)

These are the three planning strategies.

As you can now ascertain the asset allocation of a well constructed investment and retirement plan is quantifiable but it’s the qualitative stuff which separates professional advisers from the DIY and product spruikers.  For those budding DIY’s who want to have a crack – here’s a good back of a napkin calculation. Divide your required income in retirement by 4%.

The answer tells you how much capital you require at retirement.

i.e.

-              $100,000 income – for life which cannot be outlived

-              Divided by 4% - (a net drawdown figure after costs and inflation)

= $2,500,000 – capital required at retirement – to be passed on.

Question.  What asset allocation is necessary to achieve a ‘Real’ 4% return?  (a return after fees, inflation and tax)