Building a diversified portfolio to align with your goals and values
Like many things in life, working out where you’re going, where you’re at, and the gap between the two is critical.
Mentioned: Vanguard Diversified Growth ETF (VDGR)
Building a diversified portfolio goes beyond simply buying a few stocks. It is a personalised process that considers your goals and values, sets an appropriate asset allocation, selects suitable investments, finds an apt trading platform, and requires ongoing oversight. Managing a portfolio is an iterative process, although the time commitment varies depending on the choices made along the way. Let’s take a whistle-stop tour of building a portfolio for retirement that is designed to give a taste of what to consider throughout the process.
Exhibit 1: The portfolio-construction cycle
Illustrative only
Goals and values: Know where you’re heading, know yourself, know the gap
Like many things in life, working out where you’re going, where you’re at, and the gap between the two is critical. Today’s tour takes a very simplistic and hypothetical example : You are 50 years old, and your goal is to build a diversified portfolio for retirement in 20 years’ time. Based on your guesstimate of your annual spending rate, you think around $900,000 at retirement is enough and your starting point is $50,000 of net assets. You also think investing an additional $5,000 each quarter is achievable. Calculating these milestones requires some effort, but there are plenty of resources available to help.
Next, know yourself—risk is a key factor, as are your personal preferences. Risk comes in two forms: risk capacity, which is the amount of risk needed to achieve your goals, and risk tolerance, which is how you feel when markets are volatile. A younger person saving for retirement likely has a small balance, a long time horizon, and a lofty goal, leading to a high risk capacity and the need to take more investment risk. A retiree, however, may have achieved their goal and not need to take on a lot of investment risk—a low risk capacity. Risk tolerance, on the other hand, only comes into play if your tolerance is so low that you abandon your plan during volatile markets. Learning to manage your emotions through market ups and downs is an essential ingredient to successful investing.
What about your preferences? Are environmental, social, and governance considerations important? Do you think you can try to beat the market through active management, knowing there’s a possibility you might actually underperform it instead? Or are you happy to achieve market returns (that is, passive investing) as you don’t think you can beat the market? (It is tough!) And how much spare time do you have to dedicate to investing? To give some perspective, AustralianSuper employs over 250 investment professionals—it’s worth thinking about what you can really achieve with only a few hours each weekend.
Exhibit 2: Document your plan
Source: Morningstar Investor—Investment Statement Policy tool
Finally, the last step is to work out the required return. A goal-setting tool can come in handy. In this example, the starting amount is $50,000, the end amount is $900,000 (in 20 years’ time), and you’ve committed to investing $5,000 each quarter. To achieve this goal, it’s estimated that an annual investment return of about 6% is required. While Australians have become accustomed to strong investment returns over the last 20 years, 6% is quite a lofty target and requires risk-taking.
It is also pertinent to note that the below scenario does take inflation into account but does not take taxes into consideration. When planning your goals, make sure to account for taxes, as they have a significant impact on your total return outcome.
Exhibit 3: Morningstar’s goal-setting tool
Asset allocation: What mix of investments give you the best chance of achieving your goals?
Now that you’ve documented a summary of your plan, time horizon, preferences, and required return, it is relatively easy to select an asset-allocation target. Exhibit 3 shows that if a 6% return is required (and a 2.5% inflation rate or CPI is assumed), the “growth” portfolio’s asset-allocation mix is a good starting point. This targets a mix of 70% in growth assets and 30% in defensive assets.
Exhibit 4: Morningstar’s portfolio profiles
Source: Morningstar Investor
Investment selection: Selecting the right securities to support your asset allocation and preferences
The reality is that investing seldom starts with a blank sheet of paper—you normally have a super fund at the minimum. And it is important to build a diversified portfolio around what’s already in place (which you worked out in the first step). There are also tax considerations: Do you invest through super or outside of super, as an individual or through a trust or company? It’s best to seek advice around structuring your arrangements.
To continue with our very simplified example—let’s assume the $50,000 starting amount is in cash, you have no other investments, and you’ll make the investments personally. We also know you prefer a passive investment style and, like the rest of us, are time poor. There are so many ways to approach this, and that’s why many Australians seek advice. But let’s assume you did your research alongside a trusted advisor, read the Product Disclosure Statements, and selected the Vanguard Diversified Growth Index Fund—after all, Morningstar gives it a Morningstar Analyst Rating of Silver (a very favourable rating). It has a mix of 70% in growth assets and 30% in defensive assets. And Vanguard does a lot of the work for you—so the time commitment should be low.
Exhibit 5: Vanguard Growth Index Fund asset allocation
Source: Vanguard Australia—Vanguard Growth Index Fund Fact Sheet as at 30 June 2022
Finding the right trading platform
But how are you going to get your $50,000 invested? The Vanguard Diversified Growth Index strategy can be accessed a number of ways. You could open a Commsec or Nabtrade account and buy the exchange-traded fund, you might opt for Vanguard’s new Personal Investor platform, or you could invest in the unlisted managed fund. It’s important to weigh the pros and cons of the platform—including fees and costs (including how often you trade and incur brokerage), minimum and ongoing investment amounts, and platform features (like reporting). It’s important to do the work upfront to avoid transaction costs and the tax consequences of unnecessary of buying and selling. You don’t want to be selling down your investments in a few years’ time if you’re unhappy with the platform or the investment itself. Tax and transaction costs are two certainties in investing—and it’s important set yourself up for success at the outset.
Oversight and emotional management
Vanguard will do a lot of the heavy lifting in terms of rebalancing to ensure the asset allocation is maintained at roughly 70% growth assets, but it’s important that you oversee performance, make sure your ongoing quarterly contributions are invested, and periodically revisit your goals and preferences.
In terms of performance, avoid the temptation to measure the success of the investment over short time frames. After all, the suggested time frame for investment in this fund is at least seven years. And avoid panicking if markets do dip: Stick to your plan, continue with your contributions, and trust the work you did up-front. Reacting emotionally will not serve your long-term goal. However, it is important to check in episodically to make sure your goals and preferences remain intact and a revised plan is not warranted.
Today’s whistle-stop tour gives a taste of the many considerations when building a portfolio. Remember—financial planning is not about trying to accumulate as much as possible—it is about setting a clear and realistic plan that suits your life and goals. There’s no right answer to building a diversified portfolio—it is a personalised process and ultimately depends on what you’re trying to achieve.
