Investment Articles

By Ray Griffin

The expression Portfolio Construction (PC) is used to describe the way in which major asset classes (shares, property, fixed interest and cash) are brought together in a portfolio.

However, there is more to PC than just deciding to have a diversified mix of assets. Central to the decision on what that ‘mix’ should be is the need to understand the pros and cons of each asset class.

If we exclude so-called ‘exotic’ investments (see our article on 'exotic' investments) we can concentrate on the universally accepted four major classes of investment of shares, property, fixed interest and cash.

The table below highlights some of the general advantages and disadvantages of each asset class:

* Please Note that by necessity the above comparison is not exhaustive and there will be exceptions to these general aspects.
** Bond investments - paying fixed interest rates - can both increase and decrease in value subject to the direction of interest rates.

Risk vs Reward

One of the first points to note is that in the area of ‘growth’ investments (shares and property) for each advantage there is a corresponding disadvantage. Investors can sometimes fail to acknowledge the disadvantages (risks) and become overly confident in allocating to a particular growth asset class. Suffice to say that the investment world is littered with tales of overly ambitious growth (reward) expectations.

The potential for an increase in capital value (capital growth) in shares is underpinned by a vast array of factors ranging from recent company performance and company outlook to the Australian and/or world economic outlook. The price of shares in a company can even rise and fall on the inflexion of certain words used by world leaders or prominent decision makers such as central bank leaders.

Generally speaking, capital growth in the property sector is derived from rental increases and on this point I must exclude residential property which is very often subject to the emotive swings of individual buyers and sellers. However, in commercial, industrial and retail property, rental increases are most often contractually based on inflation increases. That is to say that a tenant will pay rent which increases each year in line with inflation as a minimum. This in itself is an attractive aspect because it ensures that the ‘buying power’ of the income which investors receive is not eroded by inflation. Naturally, improvements to the property(s) can also lead to rental increases.

The main fixed interest market for individual investors is the term deposit area which does not provide capital growth potential. Term deposits are in effect a loan by an investor to the financial institution which then on-lends the capital to borrowers who pay an interest rate higher than that which is paid to the depositor. The difference (the margin) in rates is revenue for the financial institution. While term deposits can sometimes be withdrawn prior to maturity it can often result in interest penalties. Note that while there is no capital growth potential with term deposits there is, correspondingly, very little risk of capital decline unless the financial institution were to fail.

The inverse wonders of the Bond market

Bond markets are a fixed interest area which also matches investors with borrowers. Capital growth and decline are everyday prospects. Typically, bond markets are trading ‘paper’ where the face value of the bond will be many hundreds of thousands of dollars making it out of reach for most individual investors. The growth and decline prospects are a function of two key issues - interest rates and the capacity of the borrower to repay the loan at maturity.

As interest rates rise – or if rate rises are anticipated – the value of bonds already on issue will decline. This is because an investor would be able to make a new loan (investment) to a borrower at a higher rate of interest rather than buy a lower rate existing bond. To compensate for the lower interest rate being paid on an existing bond, a bond seller has to accept a lower value such that the interest on it reflects the new higher rate which the lender (bond buyer) could otherwise access with a new bond (loan). This also applies to debenture investments which are in effect loans to finance companies and which can sometime be sold via bond/fixed interest markets.

Conversely, if interest rates decline, or if rate declines are anticipated, the value of existing bonds rise due to the higher rate it will pay until it matures. When interest rates fall, or are expected to fall, it is known as a bond market ‘rally’ as prices for existing bonds rise. Individual investors can access the bond market through so-called ‘bond funds’ which are unitised managed funds and the unit price will reflect the outlook for interest rates. Generally speaking, a rising unit price is indicative of falling interest rates and the reverse is true for declining unit prices. Also note that the interest being received on a range of bonds within a bond fund is accumulated/reflected in the unit price.

And of course as the old saying goes – ‘cash is cash’ and there are no capital growth prospects with it. Save for a failure of the financial institution there is no risk of capital decline.

Income

Understanding the various income characteristics of asset classes is vital in constructing a portfolio. Interest bearing investments – term deposits, bonds, debentures, cash – experience a ‘roller coaster’ pattern of income over time. In effect, what is good for the economy – i.e. low interest rates – is not good for the investor living solely off income from interest bearing investments. Interest bearing investors are delighted when interest rates rise but can despair when interest rates decline as it has a direct bearing on their standard of living.

For the property investor, rental income indexed to inflation will ensure that the buying power of their income keeps pace with inflation. For the share investor there is no standard of indexing or linking of dividend income to an economic indicator such as inflation. However, generally speaking, it’s reasonable to expect that the dividends from well run businesses will rise, in dollar terms, over time in line with inflation. This is because, assuming all other aspects being equal, a business’ revenue should increase in line with inflation as a function of it passing on the rising cost of its goods and services to its customers.

That’s not to say that dividends will always rise as a percentage return when measured against the prevailing share price. A look at the expected dividend quotes in any share market price listing will reveal relatively consistent dividend rates (expected dividend expressed as a percentage of latest share price) over time. However, share investors do experience rising dollar value dividends over time which are a higher percentage when measured against the original investment value.

Of course there are exceptions to this generally accepted principal – some businesses never make a profit –some businesses have quite erratic dividend payment patterns and some businesses fail completely.

In the next issue we’ll look more closely at liquidity/accessibility of each asset class as well as exploring their behavioral characteristics at various stages of the economic cycle. In the third edition on Portfolio Construction we’ll look at the ‘style’ of funds management to give investors insight into combining various management styles in your portfolio.

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Important note: The views expressed in this article are those of the author and do not necessarily reflect the opinions of Rabobank. Before making any financial or strategic decision you should obtain professional advice which takes into account your personal circumstances and objectives. This information in this article is not professional advice and does not take into account your personal circumstances or objectives. Rabobank accepts no responsibility for any reliance on this information or conclusions reached by you in using this information.