The path to financial freedom is long and winding. On that journey you will need to know how to create an investment portfolio. Initially this statement sounded very scary to me but that is only because it contained the words investment and portfolio. When you hear those words you think about fund managers, stock brokers the JSE and rich millionaires.
How to create an investment portfolio is nothing more than knowing what investments you have versus what you want and how to achieve this. I used to think that I didn’t need to know this because I was not planning to have a stock portfolio. I have my employer pension fund and then I just buy diversified ETFs. Well it turns out that you do need to know the basics of an investment portfolio. Even if you are a passive investor like me.
Your goals and risk profile
You need to understand your goals and risk profile so that you can know what investments are best for you.
We are all different with different needs. What is common to all of us is that we go from young to old. If you are young you have many years head of you and so you can take more risks as you have time to recover losses. If you are older you can take less risk as you are closer to retirement and rather want to protect your investments.
You should have a financial goal that will help to inform your investment strategy. My goal is financial freedom and early retirement. I have a financial plan to achieve this which you can read about in an earlier post. It is a simple plan with essentially 3 investment elements.
I have my employer pension fund, my tax free investments and then my normal investment account. My investment strategy is to buy diversified ETFs and have a 50/50 split between local investments and off shore investments. Initially I thought that this was enough. But then I learned that I could do more to make it even better.
Types of investment portfolios
If you are invested in stocks, bonds, property, commodities then it seems quite obvious that you would have an investment portfolio. You need to create an investment portfolio to make sure that you have the right balance of all these asset classes. Since I was invested in my pension fund and ETFs I thought I need not worry, but I was wrong.
Regardless of what you invest in, the portfolio is made up of a balance of assets. The table below lists some of the main asset classes and categories to consider.
There is an additional layer to consider which is local versus offshore. South Africa only makes up 1.5% of the global market. So if you want a diversified portfolio you have to invest in offshore assets. Check out this great webinar on why offshore vs local equity etfs.
These asset classes vary depending on risk vs return. The diagram below explains the relative risk and return relationship.
Remember the risk profile from earlier? Well your investment portfolio needs to mirror your personal risk profile and address your investment goals. To explain lets consider 3 types of investment portfolios.
Aggressive or high risk
This will suit a younger investor with high-risk tolerance. They want maximum growth over a long period of time, say 10-30 years. This portfolio is predominantly or completely made up of equities. There is very little or no interest-bearing bonds or cash. The returns could be very high, but the risk of loss is also higher. They are invested for a long time so they will be able to recover from down markets and show good returns overtime
Moderate or balanced
This type of portfolio has a balance of all the asset classes. Half is made up of equities and then the other half would be split between the other less risky asset classes
Conservative or low risk
This would suite older and more risk averse investors. They are looking for a portfolio with more guaranteed returns. They don’t have a long time horizon so want to preserve the investments. This portfolio has the lowest proportion of equities and the highest portion of interest bearing bonds and higher cash.
Often you will find financial institutions package their products as explained above. But nothing stops you from following the same logic or anything in-between
Three steps to create an investment portfolio
I had started to create a portfolio for myself but was still missing some pieces. That was until I attended a JSE power hour webinar hosted by Nerina Visser. The presentation covered a great strategy for putting together a passive management portfolio.
Step 1: Design your ideal portfolio
To design your portfolio you need to consider your goals and your risk profile and tolerance. A combination of these will guide you.
To arrive at the portfolio allocation I used the nifty spreadsheet from the webinar.
This spreadsheet lists all the asset classes and splits them up as a percentage of total portfolio. The min and max were guidelines as per the original spreadsheet. The NV column is my ideal target for my needs that I have decided on.
I am aiming for early retirement so my portfolio at the moment is still mostly aggressive but will move towards balanced as I get closer to retirement. So I am targeting 80% equities, 12% bonds and a balance of everything else. This is mostly driven by my pension fund which as a forced allocation that I cannot change. I will explain in the next section.
Step 2: Inventory check of what you have
The second step is to understand what you already have. I have an old provident fund and RA, a pension and provident fund with my current employer, a TFSA account and some local and offshore ETFs.
That is not enough. You have to go a level deeper. Each of these funds is made up of underlying assets. This information can be found in the fact sheets. As an example my provident fund is made up of two different funds, see below the asset allocation of one of those funds. You can see I actually have bonds, commodities and property as well.
After finding and studying all the factsheets I was able to come up with the table below. In this table I now have all of my investments categorised by asset class and the relevant categories. So now I have a clear view of what I have.
The total column is my actual allocation. From this analysis I can see that I have 73% equities with 39% local and 30% off shore. I have 11% bonds, something I didn’t even realise because it is hidden in my pension fund. I also have 7% cash, that is also because my pension and provident funds carry a large portion of cash.
What this analysis tells me is that my current portfolio is a lot less risky that I thought. It also explains why the growth has been pretty average.
Step 3: Managing your portfolio
The next step is to compare your designed portfolio with your current allocation. When you do this you will see the gaps between what you think you should have and what you actually have.
Once you have all this information it allows you to start managing your portfolio in a pro active way. Instead of just randomly buying stocks or ETFs because you like the sound of them, you now have a purpose.
Using this spreadsheet I am able to calculate an actual value target for each of the asset classes. This tells me exactly how much I should buy or sell of a certain asset class. I am still building this portfolio so the approach that I will take is to focus on buying the assets that are under represented. This will then rebalance the portfolio and reduce the weight of the over represented assets.
These are the key takeouts from my analysis
- Keep the overall equity balance by only buying ETFs
- Focus on buying more offshore ETFs
- Buy an emerging market ETF to complement the smaller portion already in the offshore ETF
The advice is to do this exercise on an annual basis or when you receive a lump sum to invest.
This exercise has forced me to understand all of my investments better. Now I know how to create an investment portfolio in 3 steps. I also have a portfolio strategy and a methodical way of managing my investments. I now know exactly what each investment consists of. When I look at new investments it forces me to understand the asset better to see how it fits with my current strategy.
You shouldn’t take any of this as advice, consult a professional financial advisor for that. This is merely what has worked for me and my experience.
Feel free to leave a comment or question below.