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Three rules to a great portfolio

This article appeared in the November 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

You need to consider the changing stages of life when allocating assets.

Photo of Dale Gillham By Dale Gillham, Wealth Within

Whenever I'm asked to write about portfolio construction, a million thoughts run through my mind about what I can say to help the reader really understand what they need to do to create a powerful portfolio. We might all like to think it's just a matter of buying some assets and holding them, but the challenge is one size never fits all. Rather, the right way is to build a portfolio based on individual goals at the time.

Someone in their 20s who is single and has just started a career will have completely different plans and goals to someone who is married, retired and in their 60s. So to put you on the right path to building a powerful portfolio, let's get a few things straight from the start.

  1. There are two levels of portfolio construction: strategic asset allocation and individual asset allocation. The strategic part is simply about the asset class/classes into which you place your money, such as property, shares, cash, etc. This allocation should be based on current needs and have a timeline of three to five years. Individual asset allocation covers the specific investments made within each asset class, such as which shares you hold.
  2. Portfolio construction is not set-and-forget, but requires periodic adjustment. Set-and-forget leads to an ineffective portfolio and reduced returns.
  3. Most investors and traders get it wrong, as do many in the wealth management industry.

When investigating asset allocation to build a long-term portfolio for retirement, you may have found that the answers you get depend on who you talk to. A financial planner will be more focused on strategic asset allocation and "buy and hold" investing, whereas a stockbroker is more concerned with specific asset allocation. One thing for certain is that everyone is interested in your money, yet you are the only one you can really trust, so it pays to understand how to create a portfolio.

For this article I want to concentrate only on developing a share portfolio, as this is where the majority make mistakes. Space does not permit me to explain this area in detail, but everything I will share with you has come from my book, 'How To Beat The Managed Funds By 20%', and for ease of understanding I have broadly broken the information on portfolio construction into three areas, with three keys to each. It follows the Rule of Three. Access the first chapter of Dale's book free.

Step one: Decide what stage of life you are in

The three portfolio phases an individual travels through are:

  1. Young adult
  2. Family
  3. Retirement.

Decide what stage of life you are in and what stage you are moving towards, as this will determine the detail of how you make up your portfolio.

Step two: Decide on the type of portfolio you want

The three types you can create are:

  1. Growth
  2. Growth and income
  3. Income.

You will hear all manner of terms from those in the industry about portfolio styles, from conservative and balanced to high growth and high conviction, yet broadly speaking they all fall into the categories I have mentioned. Generally, as individuals move through the three portfolio stages of life, they will also move through the three portfolio types. Typically you might expect a young person to have a portfolio set up specifically to gain capital growth and as they move through life the portfolio will change until retirement, where it will be aimed at gaining income rather than growth.

A word of caution. Although I have described an ideal situation, from my experience it is not normal, because many leave their retirement planning to the last minute and many in the retirement phase are constructing portfolios like those of a young adult. It is also my experience that 90 per cent of people will opt for a growth portfolio no matter what their stage of life. Both these situations happen all too often and are why the GFC was so damaging too many people either moving into retirement or retired.

Step three: Constructing the portfolio

The three key areas in constructing any portfolio are:

  1. Risk
  2. Diversification
  3. Money management.

Note that none of my three points mention buying or selling shares, or what type. This is because what you buy and sell is a direct reflection of what you decide in steps one and two, and in the three keys of this last step. Each of the three keys in step three are critical in proper portfolio management, yet I find that even many in the financial industry do not understand them or apply them well. I will briefly talk about all three.

Risk

Risk and diversification generally go hand in hand, but they are different. With sharemarket investments and indeed trades (for all you traders reading this), there are two areas of risk you need to be aware of. The first is the risk to your total capital, as this will determine your portfolio make-up; and second, the risk you take with an individual share. As a rule of thumb, I generally teach traders they should never risk more than 2 per cent of their total capital on any one share, and to use a stop-loss (a predetermined point at which you sell) of 15 per cent of the buy price for blue-chip shares.

Diversification

In the majority of portfolios, I get to see what I can only describe as "de-worsification": far too many portfolios are over-diversified.

Fact: Concentrated portfolios perform much better than widely diversified portfolios, and have lower volatility and lower risk if you follow proper risk and money management strategies. Another rule of thumb I teach is that no matter what stage of life you are in, or what type of portfolio you want, you only ever need to hold between eight and 12 shares at any one time. This leads to higher profits, less costs and less risk.

Money management

Money management, to some degree, is naturally occurring if proper risk and diversification are being undertaken. But it is more of an overlay strategy in that how you allocate capital is important. My rule of thumb here is never place more than 10 per cent of your capital into speculation; if you have $100,000 that means you should not use more than $10,000 for speculative higher-risk shares, or highly leveraged trading such as options, CFDs, foreign exchange, futures, etc.

It is a common story that businesses, builders, investors and traders have gone broke or bankrupt because they have taken on too much risk or borrowed too much. This is where my next rule applies, which says that you should always leave something on the table, or never borrow to the maximum amount you are allowed.

A final word

I don't have the space to talk about how to pick individual shares, volatility, liquidity and a whole range of other subjects, but as mentioned, I have already written a book on that.

One thing I know for sure is that a multitude of myths around portfolio construction and buying shares exist, and if you follow these myths your portfolio will suffer. One myth is that actively constructing and managing your own share portfolio is hard and time consuming, when, with know-how, the opposite is true.

Anyone with a genuine desire to achieve great portfolio returns, no matter their stage of life, can and will achieve success with a little effort and the right knowledge.

About the author

Dale Gillham is author of 'How to Beat the Managed Funds by 20%', and is Director/Chief Analyst of Wealth Within.

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