It’s time to review your investment portfolio – here’s how

When investment markets are rocky, as they certainly are now, making money doesn’t seem so easy. Indeed, instead of chasing return on capital, investor focus is turning to return of capital.

When investment markets are rocky, as they certainly are now, making money doesn’t seem so easy. Indeed, instead of chasing return on capital, investor focus is turning to return of capital. As appreciation of risk is heightened, it is important to “stress test” your portfolio to reaffirm the way you invest.

Optimising your chances of making money in the months ahead probably means having your portfolio just right. Later in this article, I’ll suggest a number of ways to analyse the makeup and performance of your portfolio and assess how you are spending your “risk budget”.

Included are a few easy-to-use templates that you can use to “stress-test” your portfolio design. But first, though every portfolio is different, when you boil it down there are three important factors: allocation, diversification and performance.

Asset allocation

How your assets are allocated between the major and minor asset classes, and especially your overall equity/bond mix, is a big predictor of return and risk. The template in Figure 1 can be used to capture this the major design feature of your portfolio; that is, the mix between investments that are “equity-like” and “bond-like”.

Equity-like includes listed company shares, which generally promise capital growth and exhibit greater price volatility. Bond-like includes investments that mainly focus on delivering income with much less or no variation in price. It is not right to call this “growth” and “income” because many listed companies offer attractive dividend yield and some bonds offer a growth return.

Figure 1: Overall portfolio asset allocation template

Skill needs to be applied allocating non-traditional investments and those that misrepresent themselves as traditional assets. A hedge fund or and even some opaque “cash-plus” funds buying and selling fixed-interest investments using high levels of gearing should be classified as “other equity-like”, not as a bond or defensive allocation, as some do.

Property is a unique asset class and, for direct property investors, it often represents a large proportion of total investments. Property provides both regular income (rent) and also offers the potential for appreciation. Accordingly, you can either describe your overall allocation in terms of an equity/property/bond mix or equity/bond mix where you allocate your property exposure 50/50 to equities and bonds.

While generally not as prevalent in portfolios, there is some logic for treating infrastructure as both equity and income-like. Unfortunately for many Australian investors, the promised regulated income has been overwhelmed by fluctuating equity-like price volatility, mostly from over-engineering and development risk. Commodity or currency positions are certainly equity-like as they offer little or no yield.

In short, your equity/bond mix measures your trade-off between eating well and sleeping well.

Generally, the higher the equity allocation, the higher is your expected return and the greater price volatility you’ll experience. Your position on the accelerator needs to align with; (i) how hard your money must work to achieve your goals, (ii) how emotionally tolerant you are to sharply declining valuations (such as those we have endured on the ASX since last November) and particularly important in retirement portfolios, and (iii) how much risk you can afford without jeopardising the life of the portfolio.

This third aspect is often forgotten in boom periods but we’re reminded of it during periods of volatility. Historic data may be used to help select what is the right mix for you and this should be re-evaluated as your stage of life changes.

For instance, if you feel you can’t tolerate a worse than 10% decline in your overall portfolio value over one year, then you should choose an allocation with no more than 60% in diversified equities based on 20 years of investment experience to March 2008. In my experience, investors more often take on too much risk then take on too little.

Now, you can make a more refined analysis of your asset allocation by working on the boxes below in Figure 2.

Figure 2: Detailed portfolio allocation template

A number of studies suggest returns from lower-priced companies (often referred to as value stocks, which may be the bottom third ranked by book-to-market ratio, price/earnings multiples or other value metric), and smaller cap companies (for example, those outside the ASX300), may over the long term provide higher returns than investing in large, growth stocks.

In turn, large capitalisation, high P/E stocks bought in an index proportion will dominate low P/E and smaller companies. Buying Woodside when it traded at a P/E of 40 meant you bought four times more of its earnings than Fairfax’s, which traded on a P/E of 10.

In the case of international investment, small countries or emerging markets deserve special attention. Investments in BRIC economies (Brazil, Russia, India and China) and smaller Asian markets have recently performed well compared to developed economies. Understanding how your equities are allocated amongst these sub classes helps uncover whether you are missing out on these sources of return and diversification.

It is also important to know what proportion of your assets are invested offshore and what proportion of those, have or haven’t hedged away currency risk. Individual investors have differing views on the need for, and benefit from, investing offshore.

While it is true many Australian companies derive profits overseas, this invariably originates from a narrow industry base. About a third of consumer expenditure is priced in offshore currencies, including your petrol bill and Miele oven. While the Australian dollar was rising, hedging helped returns. While it falls hedging works against you.

The return and risks from lending your money to others using bonds and hybrids, particularly in the form of yield investments, such as hybrids, are governed by two important factors; interest rate and credit risk.

By locking in your money into a long-term bond or term deposit you may be betting that interest rates will fall. That strategy certainly benefited investors in the late 1980s, but if rates rise again to combat inflation, the price others will pay to take your bonds off you will fall.

Lending your money to those with lower credit quality may offer increased returns, however, a 1% chance of failure or losses from one in 100 investments wipes out each 1% of excess return. (The coupon on locally listed hybrid investments ranges from 6% to more than 11%, which you should compare to either Commonwealth bond and bank bill current yields of about 5.5% and 7.5% respectively.)

Some investors, knowingly or unknowingly, chase incremental returns through these two factors. Others see the role of fixed interest as purely a defensive investment and spend their “risk budget” on equities and, accordingly, use only ultra-secure fixed interest investments.

Before this recent crisis, government, institutions, bank and company bonds with AA or AAA ratings fit this category. In today’s reality, holding cash with regulated financial institutions instead of investing in a diversified mix of quality bonds, is choosing a small risk of catastrophic concentrated failure versus a higher likelihood of encountering smaller more absorbable losses.

Property is not a homogeneous asset and understanding your exposure to the different types of properties in your portfolio points to how exposed you are to consumer spending (retail), industrial production (industrial), employment (office, residential), interest rates (all) or the neighbours (residential).

Finally, your asset mix affects the yield or income your portfolio generates. This is important for retirees and tax-sensitive investors. Estimating the yield from your portfolio is easier than estimating expected gain. However, if you know both, then you can predict your expected portfolio return and link this back to your overall needs and forecasts.


Diversification is said to be the only free lunch in finance. The premise, one that not all fund managers or investors subscribe to, is that there aren’t extra rewards for overly concentrating your portfolio.

Two important ways to think about concentration risk (the opposite of diversification) is to compare your spread of stocks among the various industries and as a proportion of total value, which you can do using the template in Figure 3.

Figure 3: Stock diversification template (benchmark % as at 30 June 08)

In the left-hand side of Figure 3, you can see the Australian sharemarket is about 60% dominated by resource stocks and financials (here excluding listed property). “Bottom up” investors in Australia may find that they are betting heavily on commodity prices and the ability of banks to lend money without blowing up.

During the five years to November 2007 this paid off, but at the moment it isn’t. If you are not investing offshore then you may be missing out on a share of profits from or spread your risk across pharmaceutical, IT, heavy industry and big oil companies, or are getting that exposure through a very small number of local players.

Industry sensitivity aside, how many stocks you have in your portfolio and what proportion of your equity allocation they represent determines your “stock specific” risk. On the right hand side of Figure 3 you can compare the cumulative percentage that your largest portfolio holdings represent against your total equity exposure. It is not uncommon to find four or five stocks in a portfolio accounting for 50% of assets – often BHP and banks.

This compares with the top five stocks in Australia representing a high third of the market (BHP, CBA, NAB, Telstra, Westpac), whereas the top five companies in the world (Exxon, GE, AT&T, Microsoft, Shell) account for only 6% of global equity value. Given the small market in Australia, it is quite easy for your retirement to depend on the success of a very small group of industries, companies and chief executives.

Some investors use managed funds, either active or passive in style, to introduce a diversified “core” exposure which minimises concentration risk. They then surround that with a “satellite” of market-beating hunches or “tilts”. Expensive Greek words for this are “beta” and “alpha”.

It is also very common for investors to go direct in Australian equities, often because you can or because that’s how your broker makes money, and then use managed funds for international investing, because of the difficulty investing there directly.

At the tail end of concentration, we find some direct investors have many small direct holdings that together account for less than 5 or 10% of portfolio value. If that’s the case you should question how much value that brings and whether this is a housekeeping opportunity.


The performance of your portfolio, especially over the medium and long term, should be compared against both your target objective and also benchmarks for like-asset classes. Studying performance over a period less than a year, also known as noise, is likely to lead to emotional exhaustion.

Performance should be studied along different dimensions:

  • Return generated for price volatility experienced, not just return alone. This will require you calculating the “standard deviation” of monthly or annual returns. As a rule of thumb, each 1% reduction in standard deviation increases by one year the earliest age a simulated retirement portfolio exhausts itself and also reduces the probability of money running out at age 85 by about 4%.
  • Risk and return if the best and worst performing stock, and the largest holding, were removed. This helps understand how dependent your return may have been on just one stock.
  • Risk and return over different time periods, for example, before and after the dot-com boom or during a boom and bear cycle. As you know there is a different season for different stocks or investment styles.
  • Risk and return versus appropriate benchmarks, like for the ASX, MSCI, value or small companies. This helps you understand if all your effort and costs trading beat a simpler lower cost passive style.
  • Risk and return versus alternative portfolio constructions; for instance, your portfolio versus one that had more or less fixed interest.
  • Turnover, measured by volume of stocks bought or sold divided by total portfolio value, which speaks to tax efficiency and cost.
  • Income versus growth, which also impacts tax efficiency and measures your dependence on uncertain capital gain.

The template in Figure 4 could be used to capture your analysis results, although completing parts of this may require professional assistance.

Figure 4: Performance summary template

There are many good reasons why Australians choose to assemble their own portfolio and invest directly. However, a precondition for doing so should be understanding what’s been built, what risks have been taken and how it the portfolio performs compared to default indices. It is not always in your stockbroker or adviser’s best interest to have this objectively assessed … but it is in yours.

Doug Turek is the managing director of personal wealth advisory firm Professional Wealth and a licensed financial adviser.



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