In the last post – How to start an Investment Portfolio – we looked at the steps and mechanics involved in creating your first investment portfolio. So we covered – setting your Objectives, determining how much Risk you will take on, your investment Time Frame, and Opening a share trading account.
This week we’ll progress from this set-up phase, to explore how you then build an investment portfolio.
We talk quite a lot about investments here at Financial Autonomy. That’s because our goal is to enable you to have choice in what it is that you do with your life, and if you have an investment pool that generates income, then some and potentially all of your living costs can be meet without you needing to trade your time for money. The freedom this provides is what can then enable you to spend your time writing your novel, learning a language, building a boat, or whatever it is that is your Financial Autonomy goal.
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Have an emergency fund
In episode 78 we identified setting your investment time frame as an essential element of planning your investment portfolio. Your investment time frame is extremely important, because it dictates the level of risk you can take, and consequently the type of investment you hold.
What would be disastrous then would be to set up an investment strategy suitable for a 10 year time frame, only to have circumstances change 6 months later and you need to liquidate. If you had bought an investment property for instance, and were forced to sell, you will almost certainly lose big time given stamp duty of probably $20,000-$40,000, plus agents selling costs of usually $15,000+, and legal costs.
So when considering how to build an investment portfolio, it is important you plan for avoiding the need to break your planned time frame. And the way to achieve this is by having an emergency fund. This is a pool of money – cash in the bank – that’s readily accessible and can get you through any unexpected financial need. If you have a mortgage, it’s probably money you would have in your offset account or perhaps redraw.
How much should you have in this emergency fund? As a rough guide, enough to cover 3 months of living expenses would be a good start. Depending on what you have going on in terms of debts and expenses, it may well need to be more.
You’ve set your investment objectives. You’ve determined the degree of risk you can tolerate, and your time frame. These are all core inputs into the next step of building your investment portfolio – investment selection.
Firstly, what are your options? From lowest to highest risk, it looks like this:
- Cash in the bank
- Fixed (term) deposits
- Listed Property trusts
- Domestic share portfolio
- International share portfolio
- Direct property
- Geared investments
Let’s look at an example to see how the inputs of objective, risk tolerance, and time frame come together.
Objective: Invest $100,000 for pure growth over the next 10 years, so that at the end of that period I can quit my job and take at least a year off to consider what I want to do with the rest of my life.
The time frame is covered there in the objective, and given you are after pure growth, your tolerance for risk (experienced as volatility) is high – all that matters is that in 10 years’ time, your savings have grown. The ups and downs in between really don’t matter.
These parameters might result in an investment selection that is 70% international shares and 30% Australian shares, potentially with the use of some gearing to magnify returns.
Dollar cost averaging
When considering how to build an investment portfolio, another important factor is whether you will invest a lump sum at a single point in time, or instead invest progressively over time. This progressive type of investment is known as dollar cost averaging, and unintentionally you are using this strategy already via your employer super contributions.
There are two ways you might deploy dollar cost averaging when building your investment portfolio. If you have a lump sum to invest, you might choose to place this into investments over several regular intervals – so for instance rather than investing $100,000 on day 1, you might place $35,000 on day 1, another $35,000 a month later, and the final $30,000 a month after that. In this way you are averaging your entry price. The goal is to reduce the risk that markets were at a short term peak back on day 1.
The other way dollar cost averaging is used is for regular savings plans. As mentioned earlier, your superannuation contributions use this strategy. Contributions are made regularly, usually monthly, and you buy at all points in the market – during strong periods and weak. When markets are down, your savings simply buy more units or shares, than when markets are stronger.
The most important element of a regular savings dollar cost averaging plan is to stick with it when markets are experiencing weak periods. During these periods, some investor’s natural inclination is to want to stop investing, or put everything to cash. But it’s essential you remember that through this strategy you are a buyer. And as a buyer, you want the lowest price possible. Continuing to invest during down markets is key, because it pulls down the average price that you have paid for your investments, and thereby underwrites your future investment growth.
When you’re thinking about how to build an investment portfolio, selling might not spring to mind as a key consideration. Yet selling is a necessary part of managing your portfolio, and is the area with the greatest potential to dislocate your investment trajectory.
The first time selling might crop up as an issue for you is when the performance of one of your investments is negative. A reasonable question to ask is “have I chosen a dud here?” The first thing to remember is that if you’ve built a diversified portfolio, the very embodiment of diversification is that the investments go in different directions at different times. If everything in your portfolio goes up for instance at about the same rate, then you’re really not diversified.
So if you look at your portfolio, and say the Australian and International share portions are up, but the listed property portion is down, this doesn’t mean the appropriate action is to sell off the property portion. In 18 months’ time when the shares have a down period, it may be the listed property that shines – that’s why you diversify.
There might be times where you sell investments over the life of your investment portfolio, and this is particularly the case where you have a direct share portfolio, that is, you haven’t used funds like ETF’s.
If you’ve chosen to build an individual stock portfolio, then you will have accessed some sort of research to help you chose what to buy in the first place. This research will typically offer Buy and Sell type ratings. In managing this style of portfolio, you will need to keep abreast of these Buy and Sell indicators, and take action when they change. A word of warning though. Some of these systems flip from buy to sell a lot. So you might want to have some rule that you only sell if the stock has been rated a sell for more than a particular period of time, like perhaps a month. Otherwise you risk being tipped out of stocks due to short term spikes, when they may have been great long term holdings.
The most obvious time to sell is when it aligns with your original objective. So say for instance you’re building up an amount for a home deposit. Then of course you sell when it’s time to buy your home.
At this point an important consideration is capital gains tax. I’m not going to get into the specifics of how this is calculated here, but suffice to say, if your investments have risen in value, there will be some tax to pay. Ensure you have set some money aside for this liability, as it could be 12 months down the road, when you lodge your tax return, that this becomes payable. If you’ve used every cent of your sale proceeds on your home, where will the money come from for your Capital Gains tax debt? Get your financial planner or accountant to provide an estimate of how much you will have to pay, and set this amount aside.
A final word on selling – don’t try and be a short term trader. By that I mean someone who buys and sells shares, or sometimes other financial instruments like foreign exchange, frequently. Short term buying and selling is almost guaranteed to lose you money. It’s just gambling, and like all forms of gambling, whilst you might occasionally get lucky, keep playing for long enough and eventually the house wins.
We’ll that’s it for this week’s post on How to build an Investment Portfolio. To summarise, the key elements are:
- Have an emergency fund
- Investment selection
- Dollar cost averaging
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Resources & Links
- How to start an Investment Portfolio
- My 68% return. The power of gearing – how smart borrowing can accelerate your journey to financial autonomy
- Gaining Choice Newsletter