Meet your money needs with a tailored strategy

I OCCASIONALLY meet people who want to talk about investing for retirement. The question is usually along the lines of: "I know I should have a diversified portfolio, but how do I do it? What's the best mix?"

I OCCASIONALLY meet people who want to talk about investing for retirement. The question is usually along the lines of: "I know I should have a diversified portfolio, but how do I do it? What's the best mix?"

My first response is to tell the investor to find an investment adviser - a financial planner.

But there are some retirement investors who don't want an adviser or feel they can't afford one, and there are thousands of people with self-managed super who may not have ongoing investment advice. These people need a rule of thumb they can work with.

That rule of thumb is an approach called portfolio optimisation, which is not a passive "set and forget" strategy with a fund manager, but involves the active creation and management of a portfolio that chases a certain return.

It's something the big professional fund managers are always going for, but they have to create funds with an investment mix that is "off the rack" and suits many investors, whereas you can tailor a portfolio that is optimised for your specific needs.

There are three factors when considering portfolio optimisation, a concept that is the specialty of RP Data-Rismark economist Chris Joye and a subject he often writes about.

The first is your target return. This is the return you want from all your investments - it decides how much you have to spend when you retire. Typically, you want to start with an actual sum so you can use an online calculator. This is where you start deciding what kind of assets and what kind of yields are in your portfolio. And, typically, the higher the annual returns you are chasing, the higher the risk.

Which brings us to the second factor in portfolio optimisation: your risk.

There are many ways of defining risk. There is risk that an investment will not reach what was expected there is the risk that your investment does not outpace inflation there is risk of volatility, so that an investment may reach its desired peak but not when you want to cash out.

The way risk is so often marketed to amateur investors is as a risk-return equation, as if it were a scientific formula. But if you are not a professional, I think it is quite reasonable to see risk like this: it is the risk that you won't get back as much as you put in.

This is not scaremongering. As you age, and your time in the workplace grows shorter, you have less margin to earn back the money you lost on an investment. As you close on retirement age, the risk you face is very much that you might go backwards right when you don't want to.

See it this way: for most Australians, their biggest asset is the family home. This forms the backbone for many retirement plans, yet we know that one in 10 vendors of real estate loses money.

The third factor in portfolio optimisation is one of correlation. That is, you can insulate the risk inherent in one type of asset by investing in a different asset with an unrelated risk characteristic.

Bearing in mind these basic factors, it is fascinating to read Joye's research into which asset mixes performed best from 1982-2012. For non-home owners over this period who opted to buy one investment property, this was their optimised portfolio: 46.8 per cent in cash 36 per cent in Australian government bonds 9.2 per cent in Australian shares and 8 per cent in the investment property. Note the weighting of the high-risk/high-return Australian shares had in this optimum portfolio.

The optimum investment portfolio for home owners from 1982-2012 is also interesting: the family home plus one investment property should have been 60 per cent of the portfolio 21.9 per cent should have been cash 10.9 per cent Australian government bonds and 7.2 per cent Australian shares.

What is missing from both these scenarios? Volatile listed property trusts and global shares.

And what is weighted high? The boring stuff such as cash and bonds.

Exercises such as these are valuable because they illustrate what performs over three decades, and Joye's figures are presented as a mix - an optimised portfolio with a high degree of uncorrelated investment. If one investment goes bad, the rest don't have to follow.

I have been predicting for a while that Australians are going to move their retirement savings to fixed-income investments such as cash, bonds and products that optimise a blend of fixed-income sources.

Fixed-income products have reasonably high returns with nowhere near the volatility of equities. And as Joye's research shows, they seem to be a good portfolio fit with property ownership.

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