Construct Investment Portfolio

Construct your investment portfolio

Every one of us has financial goals but not many of us know how to go about achieving them. We often lack investment knowledge or expertise to design an investment plan that optimises our savings. Consequently, we adopt the default approach of leaving all our savings in bank deposits.

By doing so, we have already made an asset allocation decision, one that is very conservative. Over time, we soon realise that this conservative investment plan is simply not working as our savings are not compounding fast enough to keep up with inflation. We need to invest more wisely so that our savings earn sufficient returns to pay for grocery bills, holiday trips, as well as our retirement.

IMPORTANCE OF ASSET ALLOCATION

Research has shown that a key determinant of returns from investments is asset allocation. An influential study by Brinson, Singer and Beebower found that asset allocation explained almost 92 per cent of returns earned in pension fund portfolios. Asset allocation refers to the mix of asset classes that you select in your portfolio. The assets that an investor typically includes in a portfolio are deposits, bonds, equities, properties, commodities, and alternative investments such as hedge funds, private equity, collectibles.

We hold deposits primarily to finance our daily expenditures and to meet emergencies. Deposits provide us with the benefits of liquidity, safety of capital and interest. Bonds and equities are less liquid and are held to generate returns for future consumption. Bonds are longer-term fixed income instruments that earn a higher return than deposits. At maturity, bonds also return the principal back to investors. Bonds are more risky than deposits as bondholders can incur capital losses if the bonds are sold prior to maturity.

Equities provide investors with the best potential for capital appreciation but at high risk. Examples of equity instruments are common stocks, unit trusts, ILPs and Real Estate Investment Trusts (REITs). Beyond deposits, bonds and equities, investors can also invest their savings in properties, gold, precious metals, commodities, hedge funds and private equity funds.

You can construct your investment portfolio in a systematic way by following six simple steps, as shown in the diagram.

STEP 1: IDENTIFY YOUR FINANCIAL GOALS

Typical goals that investors seek to achieve are acquiring assets such as a car, property or country club membership; financing the education needs of their children; and retiring comfortably.
As you can see, some of these goals are long-term while others are short-term. You should always set a realistic time-frame for achieving your goals. If your goals are too ambitious and if your time horizon is too short, you will have to save more or take more risks in order to attain those goals. Giving yourself ample time to invest leaves you with more options with regards to your investment plans. Therefore, the first step in investment planning is to identify a target sum that you wish to accumulate within a specified time period.

STEP 2: DESIGN AN ASSET ALLOCATION THAT ACHIEVES YOUR FINANCIAL GOALS

The financial goal that you wish to achieve is a key determinant of the composition of your investment portfolio. If you are planning for your children's university education in four years' time, then your portfolio must comprise primarily bonds and deposits rather than equities. If you wish to retire comfortably with a sizeable income to spend during retirement, then you must invest in a portfolio that yields a high rate of return. Suppose the required return target is 8 per cent. Such a high return target over a prolonged period requires that most of your savings be invested in equities. On the other hand, if you are more modest and content to spend less during retirement, then your return target can be lower; say, 5 per cent. You can now afford to take on less risk and invest in a mix of deposits, bonds and equities to achieve the required 5-per-cent return.

STEP 3: DETERMINE YOUR RISK PROFILE

Good financial planning involves choosing an investment plan that fits your risk profile. Your financial risk tolerance reflects your attitude towards incurring losses in investments, experiencing volatility of returns as well as facing disappointment at not achieving your goals. If you are averse to losing money, uncomfortable with the volatility of returns and emotionally upset about falling short of your target objectives, then you have low-risk tolerance, or high-risk aversion. Your risk profile would require you to invest in a low-risk portfolio that protects your capital, has relatively stable returns and has a high likelihood of attaining a particular target value.

On the other hand, if your financial risk tolerance is high, then you are not averse to making losses. This means that you are willing to risk an unpleasant outcome of huge losses for rewarding outcome of large returns.

STEP 4: CONSTRUCT YOUR ASSET ALLOCATION

Once your risk profile has been determined, you can construct an investment portfolio that is consistent with your risk tolerance. There are a few established methods for deriving your asset allocation.

a) Asset allocation based on your risk profile
The first method is to classify an investor into one of four standard risk profiles and thereafter map these profiles into the asset allocation prescribed in the table. For example, if you are a retiree who is risk averse, the appropriate asset allocation for you is to invest 30 per cent of your savings in stocks or risky assets, 60 per cent in bonds that yield stable income and 10 per cent in deposits. On the other hand, if you are a young adult and have an appetite for risk, you can invest 70 per cent of your savings in stocks or risky assets and the remaining 30 per cent in bonds.

b) Customised asset allocation based on investor's risk tolerance
This approach uses an optimisation model (such as mean-variance model) to identify the efficient frontier derived from the asset classes pre-selected by the investor. You will need computer software to trace out the efficient frontier of portfolios. Thereafter, the optimal portfolio is determined by maximising the Sharpe Ratio. The ideal portfolio mix of deposit and risky assets for the investor is finally customised according to his risk tolerance score.

STEP 5: PERFORM A GAP ANALYSIS

It is important to verify whether the prescribed asset allocations in Steps 2 and 4 are identical. This is known as a gap analysis. A gap exists if there is a conflict between the asset allocation that achieves your financial goals and the one that fits your risk profile. Most investors face a dilemma in that they want high returns but are reluctant to take risk. To resolve this gap, you can: a) Moderate your goals; b) Take more investment risk; and c) Invest more money. You should seriously question whether you are comfortable with the level of investment risk required to achieve your goals.

STEP 6: FINE-TUNE THE ASSET ALLOCATION TO FULFIL YOUR UNIQUE REQUIREMENTS

The initial asset allocation derived from the first five steps is your strategic asset allocation. This is further fine-tuned to accommodate your unique requirements, such as investment horizon, tax considerations, liquidity needs, and personal preferences.
Sometimes, investors have strong views about the short-term performance of various asset classes and may wish to increase or decrease the weightings specified by the strategic asset allocation. For example, if you expect the stock market to perform strongly compared to the bond market next year, you may increase the percentage allocated to equity and decrease the percentage allocated to bonds. The final asset allocation is regarded as tactical asset allocation.

The asset allocation decision is a key decision in the investment planning process. Asset allocation determines critically whether your portfolio will generate a return consistent with your goals and risk profile. By following the six-step process, you will be able to develop a feasible investment plan that enhances your financial well-being.

Dr Benedict Koh is a professor of finance at Singapore Management University and director of the Centre for Silver Security. The content of this article draws heavily from chapter 8 of "Personal Financial Planning" by Benedict Koh and Fong Wai Mun.