Where property should sit in your investment portfolio: Pete Wargent

If I were to suggest an efficient (i.e. balancing risk and return) portfolio allocation for a young person to target a wealthy at retirement 65, it could look something like the below.  In order for a portfolio like this to work, you only need two things.

One is the discipline to be careful with your spending to ensure that you can pay a good amount into your investment portfolio each month.  The second thing you will need is time to allow the portfolio to compound and grow.

A diversified portfolio: the slow but sure route to wealth

Based upon historical averages, it has been suggested that it may be reasonable to expect a portfolio like the one in the table above to achieve average returns of 10% per year or higher.

It is diversified through funds, but also diversified in that the individual components of the portfolio do not act in a correlated manner.  In other words, while, for example, when stocks are not performing well other assets, such as bonds, may well be.

The portfolio includes assets that are traditionally used to hedge against deflation (gold mining companies and bonds) and also those that thrive in more inflationary economies, such as equities and A-REITS (what used to be called Listed Property Trusts - they invest mainly in commercial properties that may be beyond the reach of the individual investor).

Stocks are commonly acknowledged to be the best performing growth asset in terms of percentage capital growth measured over time.  Bonds are often considered to be lower risk than shares (in the event of a company being wound up and assets liquidated, debt holders and secured creditors rank higher than equity investors) and therefore tend to command a lower return.

Therefore, a portfolio of this nature is efficient as a fair percentage of the investor’s portfolio is exposed to equities, with the remainder a mixture of bonds, property and cash.

Why not invest your capital 100% into stocks, then?  Well, plenty of people do, and when they hold for the long term they are often very successful too.

One reason that this may be better avoided is that if your whole portfolio is in shares, then it can be very nerve-wracking during a stock market crash which can result in investors abandoning the strategy at precisely the wrong moment.

Diversifying into assets that do not act in a correlated manner with stocks can help you to sleep soundly at night.

Once a portfolio like this is created it requires virtually no active management at all.  That said, it would make sense to rebalance the portfolio once per year as suggested in The Gone Fishin’ Portfolio by Alexander Green.

This means that if, for example, the emerging markets fund is steaming ahead, the investor might choose to sell a portion of it in order to rebalance the portfolio (i.e. that no one investment represents a significantly higher percentage of the portfolio than the rest).

Better still, the investor may choose to add more dollars to the lagging assets, a strategy that will avoid an unnecessary capital gains tax bill through selling.

While it may feel counter-intuitive to put more dollars into the lower performing assets, it needs to be remembered that assets tend to perform in a cyclical manner, and the asset class that has forged ahead is likely to subsequently have a period of low returns (and vice versa).

Problems with this approach 

Diversification is one of the fundamental conclusions of the ‘modern portfolio theory’.  Spreading your capital across a broad range of investments has the benefit of reducing the risk of loss of a large percentage of capital. 

The problem with diversification is that is almost guarantees that your results will be average, which has left sceptics to instead term the practice “de-worsification” – protecting the returns from being “less worse”. 

If you want to become wealthy more quickly, you will need to seek returns that significantly outperform and that are better than average, and the way to do this is to specialise.

If you have ever played poker or bridge you will instinctively know that diversification is not the way to win the game outright.  To win the game you do not divide up your capital into 10 equal parts and bet 10% of your capital on each hand regardless of the strength of the cards you hold. 

The winner will be the player who places big bets on higher probability hands.  This is a concept that can be successfully applied to asset allocation in your investment portfolio if you want to quit your job earlier than the traditional retirement age. 

The other problem with the balanced approach shown is that it lacks leverage. A carefully balanced portfolio, such as the one detailed above, may be perfect if you were starting with investment capital of a few million dollars, however, most of us start out with very little or nothing, and therefore it can take a long time to start seeing any meaningful results. 

This is where leverage can be so beneficial for the average investor. 

The asset class that gives you the leverage to power ahead 

The asset class that allows you achieve more with less is property, and particularly residential property. 

Banks will generally lend a high loan to value ratio (LVR) on property and this allows investors to significantly increase the value of their assets that can then grow for them to create wealth. 

Personally, for the long term I am bullish on Australian residential property and believe that due to strong population growth and our inflationary economic environment, a good bet for the average investor lies in exposure to this asset class.

Pete Wargent holds a range of finance and property qualifications and is the author of Get a Financial Grip – a simple plan for financial freedom.

For more on where property fits into your wealth-creation portfolio, sign up for our free webinar on Thursday, November 29 at 12.30.