On OpenInvest, this means choosing the right Model Portfolio category, one that suits your time horizon and ultimate goals.
In making this choice it helps to understand which aspects of the investment process are within your control.
As an investor you can directly control how much risk you take, the costs you’ll incur, your time horizon, and the inevitable emotions that come with the rise and fall of global markets. Completely beyond your control are the returns that you’ll get.
So, before you even start investing, realise that it’s more beneficial to focus on the things you can control rather than the one thing you can’t.
What level of risk are you comfortable with?
The level of risk you’re prepared to take is the most important choice you can make, and it’s governed by two traits that are personal to you and your circumstances: your risk tolerance and your risk appetite.
Risk tolerance is a function of your current assets, your time horizon, and your forecast financial needs; it can be estimated by looking at your capital, your income, and your personal circumstances such as age, number of dependants, and spending needs.
In general, young people should be able to tolerate higher risk than those nearing or in retirement. This is because young investors are lucky enough to have an abundance of one of life’s precious commodities: time. They have the ability to recover from any dip in their capital value by taking advantage of the compounding effect that only time can give.
They also have many years of income earning ahead of them, some of which can be diverted to saving. On the other hand, someone nearing retirement will need to rely on their nest egg to produce a sustainable income in their retirement. They don’t have the same length of time nor a regular income to help them recover from a down market.
Risk appetite is your personal feeling about taking risk. Some investors are very risk averse and the prospect of losing money makes them uneasy about investing. Others are happy to take on risk for the chance of a large payoff.
What if appetite and tolerance are misaligned?
Problems arise when someone’s risk tolerance doesn’t match their risk appetite. Two obvious examples highlight this. A young person starting out in the workforce with a long career ahead of them, saving for their retirement decades in the future, should be investing in a high-growth/high-risk portfolio. However, it is unfortunately quite common for such investors to be very cautious in their investments.
According to a Deloitte Access Economics study young Australians, for whom risk tolerance should be very high, have too low a risk appetite and prefer investments with guaranteed income or stable returns.
At the other end of the spectrum, investors nearing retirement, who should be invested in a conservative portfolio, will often instead own a portfolio consisting of shares in a small number of listed companies.
Misunderstanding risk tolerance can lead to undesired outcomes. Young people who own a portfolio which is too timid, with not enough exposure to growth assets like shares, can find that they are significantly worse off later in life.
A simple example below gives the outcome for an investor saving $200 a month for 30 years at two different rates of return.
The extra $131,620 is an additional return for accepting a higher risk which almost doubles the final value of the investment. Compounding at a higher rate over a long period is the key to a young person’s investment success. Imagine the difference to a retiree’s lifestyle of these two different outcomes. The results speak for themselves.
Conversely, an older investor would be in a catastrophic position if she were to lose 20% of her capital on the verge of retirement. For an older person, earning potential and time are in short supply and their approach to investment risk should realistically address these two constraints by reducing risk and increasing stability gradually before they reach retirement. The importance of diversification and portfolio selection is vital to protect the assets that have been built up over a lifetime.
Be prepared to adjust
As a rough guide, a typical investor should incrementally de-risk their portfolio as their investment objective draws closer and/or as their age increases, although this is not always the case as each individual might have their own particular facts that would vary this general principle.
Some investors might need to be prompted to adjust their risk appetite to ensure they are investing in a way that is consistent with their situation – with their risk tolerance. If this is you, seeking the assistance of a licensed financial adviser, or at least discussing your situation with your accountant, would be a good idea.
OpenInvest’s Model Portfolio categories
There are four Model Portfolio categories on OpenInvest, each of which is applicable to a particular risk-return profile, described below. Each of the investment managers on OpenInvest manages a portfolio in each one of these four categories.
The descriptions should enable you to determine which risk-reward profile is most applicable for you given your stage in life, your objectives, and your risk tolerance. Again, if you are not sure which is right for you, you might like to discuss this with your accountant or see a licensed financial adviser.
This Model Portfolio will suit you if you would not be comfortable with significant fluctuations in the value of your investments over shorter time periods. This is the most cautious of our four Model Portfolio categories and aims to protect you against a fall in the real value of your portfolio (that is, after inflation) by investing largely in Defensive assets, meaning the portfolio will seek to generate a moderate income. Each investment manager will generally be targeting an annual rate of return of 1-2% above inflation over the long run for their Model Portfolio in this category. As a rough guide, this Model Portfolio will typically consist of 70% Defensive assets and 30% Growth assets, however, each investment manager will manage allocations based on their investment strategy and approach, and their assessment of conditions.
This Model Portfolio will suit you if you are looking for sustainable income from your portfolio. This portfolio takes more risk than the Defensive Income portfolio, seeking to deliver higher growth and income. You have a reasonably long-term time horizon and are not particularly sensitive to changes in the value of your portfolio over shorter time periods. Each investment manager will generally be targeting an annual rate of return of 2-3% above inflation over the long run for their Model Portfolio in this category. As a rough guide, this Model Portfolio will typically consist of 50% Defensive assets and 50% Growth assets, however, each investment manager will manage allocations based on their investment strategy and approach, and their assessment of conditions.
This Model Portfolio will suit you if you are focused on long-term growth within your portfolio, and you are not sensitive to changes in the value of your portfolio over shorter time horizons. This portfolio category has a higher allocation to Growth assets than our Sustainable Income model but a lower allocation to Growth assets than our Maximum Growth model. Each investment manager will generally be targeting an annual rate of return of 3-4% above inflation over the long run for their Model Portfolio in this category. As a rough guide, this Model Portfolio will typically consist of 30% Defensive assets and 70% Growth assets, however, each investment manager will manage allocations based on their investment strategy and approach, and their assessment of conditions.
This Model Portfolio will suit you if you are focused on long-term growth and are comfortable with the corresponding higher risk and volatility that comes with this approach to investing. This portfolio category has the highest orientation to Growth assets of our four Model Portfolio categories. Each investment manager will generally be targeting an annual rate of return of 4-6% above inflation over the long run for their Model Portfolio in this category. As a rough guide, this Model Portfolio will typically consist of 10% Defensive assets and 90% Growth assets, however, each investment manager will manage allocations based on their investment strategy and approach, and their assessment of conditions.
The correlation between risk and return is always there
Another way of showing the four different Model Portfolio categories is on a risk-return graph, something we looked at in the article Risk and Return are always correlated.
You can see that potential rewards increase hand in hand with the risk of each portfolio which corresponds with an increasing portfolio allocation to growth investments.
As with all investing, allowing sufficient time for your investment objectives to be fulfilled is important.
The Model Portfolio descriptions refer to the objective of X% above inflation per annum, but this does not mean the investment manager will achieve this outcome each year. The objective is to achieve this outcome on average over a longer time horizon, typically over five years.
This does not mean you should consider that you are in any way ‘locked in’ to your investment with any investment manager, just that the manager has a long-term time horizon.
These four Model Portfolio categories are designed to maximise the chances that you invest in a managed portfolio that is appropriate for your risk-return situation and objectives and to help you manage the unavoidable emotional ride that the markets can often bring.
They help to keep an investor’s focus on the reason why their portfolio is allocated across different asset classes in a particular way in the first place. They prevent poorly-timed, emotion-based decisions and help keep you on course.
The market and your asset allocations provide the returns — it’s the one thing that you can’t control — but by understanding that, and staying focused on your long-term objectives, you can turn your mind to the parts of investing that you can control … or even more important things such as your family, your friends or your golf game.
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About the author:
Angus McLeod is a 25-year veteran of the financial markets, having spent 12 years as an equity portfolio manager. He holds a degree in Economics, a master’s in Applied Finance, and is a CFA charter holder and a CIMA® certificant. Angus is a lecturer in the Master of Finance course at RMIT University.