You’re ready to start your portfolio, now what?

Schalk Louw, portfolio manager at PSG Wealth
Schalk Louw, portfolio manager at PSG Wealth

So you’ve taken the first step towards starting your own investment portfolio, but what happens next? You’ve got your investment goals straight: maximum growth. But your goals need to be a lot more specific.

Let’s suggest that you have R900 000 available to invest and you’re aware of the fact that this amount has to grow to roughly R5m over the next 15 years in order for you to retire in a manner in which your current lifestyle can be sustained.

You grab the nearest unit trust guide and see that local South African multi-asset, high equity balanced funds have delivered an annual return of 13.2% after fees and before taxes and that seems good enough. Only 12% growth per year, how hard can it be?

While under the impression that you have done enough, you start searching for funds or asset classes that have delivered 12% return over the past one to two years.

Unfortunately, however, you haven’t done nearly enough. In fact, you’re just about halfway through. You’ve set your investment goals and you have converted those goals into requirements that you need to follow in order to achieve your investment returns. But you haven’t identified your level of risk tolerance. You haven’t looked at the asset allocation that falls in line with your investment return goals and risk profile.

To achieve 12% growth per year, you would have to be willing to include a standard deviation (annual volatility) of about 10% per year in your portfolio. That means that you must be willing to accept a 10% rise or decline in your portfolio at any given time over a 12-month period. 

Asset allocation is the single most important decision you have to make when compiling your investment portfolio. Studies have shown that 80% of an investment portfolio’s success can be attributed to asset allocation alone. Other considerations such as asset selection or market timing have a much smaller impact on long-term performance. 

Asset allocation becomes much easier once you break it down into several steps:

Step 1: The risk determination 

The further away you are from retirement, the more you can allocate towards shares. Your weight in shares should be higher when you are in your twenties with a gradual decrease in weight as you grow older.

But how do you know how much you should allocate to shares? This will depend on your specific goals and risk profile. Allocating around 75% to shares (local and offshore) is usually a good benchmark for a young investor with a moderate risk profile, looking to save for retirement via a retirement annuity, while someone who plans to retire within the next five years should act much more conservatively.   

Step 2: Selecting the right asset classes 

In asset class selection, as with most things in life, keeping it simple will serve you best.You want to be well diversified without any unnecessary overlaps or redundancies. 

Step 3: Slicing the pie 

Once you have determined which asset classes you would like to include in your investment portfolio, your next step is to decide how much weight you should allocate to each. Basically, you have to ‘slice the pie’ by dividing your portfolio into different percentages allocated to different types of investments. 

This decision should be in line with your personal risk profile and the goals you set in terms of achieving your required growth. Most investors would probably choose to invest more in shares when considering this asset class’s average returns of 15% per year before taxes over the past 20 years, compared to bonds’ average annual return of 12.5% before taxes.

With bonds consisting mostly of interest, this should make a considerable difference to your grand total. But with shares’ standard deviation of 19% vs. 7.5% on bonds, it also means that you must be willing to take the risk of losing 11.5% of your portfolio over a 12-month period in order to achieve 2.5% more long-term growth (before taxes). 

For most, the stakes are worth it, but by slicing your pie correctly, you can achieve higher growth than by investing in bonds, but at a lower risk than investing in shares alone.

This article originally appeared in the 11 August edition of finweek. Buy and download the magazine here.

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