The first step in building your portfolio

What’s the first thing you should do when constructing your portfolio? Virtually all practitioners (including us) agree that it is honestly assessing your own tolerance for risk.

Conventional industry wisdom defines risk as ‘volatility’; the amount the price of an asset moves around. To us, the financial nature of risk is more nuanced and we’ll discuss it in depth next week.

A financial adviser might assess a client’s ‘risk tolerance’ based on a combination of their life stage and financial position. A really good adviser will take their psychology into account, too.

This aspect is so critical, in fact, that we believe it should come first in the process; ahead of considering your financial position and life stage.

The reason is that you might have the financial position and time on your side to withstand the inevitable setbacks your portfolio will face but that will count for little  if you don’t have the stomach for it. Panicking at the wrong time (and it’s almost always the wrong time to panic) is one of the costliest mistakes an investor can make.

It’s self-evident that the best time to sell is during a boom and the best time to buy is after a crash. But this is a psychologically taxing course. And most people aren’t mentally tuned for it; which explains why booms and busts happen in the first place.

The good news is that if you have the right attitude, or are willing to cultivate it, you’ll give your portfolio every chance of performing well over the long term. And investing within your psychological comfort zone should help not only your financial returns but your health and relationships, too.

So, how to work out your psychological risk appetite?

Determining your psychology

There’s no simple way to answer the question but there are three key criteria that will help steer you in the right direction.

1.  Are you a ‘needs’ or an ‘opportunity’ investor?
   
   This is part psychological, part financial. Do you invest according to your needs or simply take the opportunities presented?
   
   Fund manager Don Brinkworth said it well; ‘profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.’
   
   A share doesn’t know you own it and the sharemarket owes none of us a healthy (or even positive) return. Opportunities to invest on outstanding terms present themselves only occasionally.
   
   If you can tolerate your asset values (and income) bouncing around like a yo-yo, you can invest more aggressively. But if you need or prefer more consistent returns, your choices will be limited. You’ll need to be more conservative and sacrifice some potential return.
   
   The same rule applies if you have a definite need for the capital you’re investing. Funds required in the short term should not be exposed to the fluctuations inherent in an aggressive investment.
   
   This principle caught out many investors approaching retirement during the GFC. They were emotionally committed to an impending retirement date, yet investing as though they were indifferent to whether it occurred that decade or next.
   
   The targeted retirement date should have dictated a conservative approach, which would have shielded investors from losses and provided the flexibility to be more aggressive as prices fell and buying opportunities arose.
   
   Yet Australia’s self-managed superannuation funds (SMSFs) had a higher percentage allocated to shares (generally considered the riskiest asset class) at the top of the market in 2007 than they did in early 2009 at the bottom.
    
2. Methodical or emotional?
   
   This applies to both your research process and your reaction to events. If a bout of downward market volatility has you nervously eyeing the plummeting value of your share portfolio (and maybe doing some selling) then you’re too aggressively invested. Periods of upheaval are the time to be hunting for bargains.
   
   You also can’t be eyeing the performance of those around you. Investing is no place to be ‘keeping up with the Jones’ since the crowd is often wrong – sometimes disastrously so.
   
   If you’re going to invest aggressively you need to be able to chart your own course otherwise you run the risk of being drawn to popular investments which, in the investing world, usually means expensive. Buying popular, expensive investments may work for a while but will ultimately lead to poor long-term returns.
   
   If you have a consistent, methodical approach to investing generally, then a more aggressive portfolio might be for you. But not if your efforts are likely to be more haphazard and inconsistent – for instance, leaving your portfolio untouched and then jumping in response to a comment in the financial media.
    
3. Tolerance of variance
   
   One of the great myths of financial planning is that various asset classes have a pre-determined ‘expected return’. They don’t. Higher risk assets tend to have a greater range of potential outcomes (or ‘more variance’). Let’s translate that using a plain English example.
   
   Take shares, for instance. Over the next decade, they might return you 10% per annum, 2% per annum or not even return your capital. The sharemarket is cheaper now than it was in 2007, but we don’t know for certain whether it will turn out to be cheap or expensive when we look back a decade from now.
   
   To invest aggressively you need to be comfortable with this uncertainty. If you’re looking for a more certain outcome you should take a more conservative approach.

To be a successful aggressive investor, you must be able to remain calm in a falling market (property or shares). Or, even better, have a tendency to become excited by the prospect of adding well-priced investments to your portfolio.

Of course we’d all like to think of ourselves this way and it’s often not until we’re placed beneath the blow torch of experience that we find out our true psychological disposition under stress.

There’s no shame in not having the requisite mentality to be an aggressive investor. In fact, you’re much better off under-estimating your tolerance of variance and risk than you are over-estimating it.

For instance, you’re better off finding out that you’re completely comfortable with the idea of going from a 20% weighting in shares pre-GFC to a 30% weighting post-GFC, than you are to find out you’re completely uncomfortable with the losses incurred with a 40% weighting and not being willing to spend a cent when assets are cheap.

A realistic appraisal is what we’re after. That will provide the best chance of avoiding putting ourselves in a situation where emotions might lead us to take action that relieves short term psychological stress but causes long term financial harm.

Getting your psychology right

If you’re 25, with a secure job, you don’t have to be aggressive. Similarly, if you’re 65 and retired, you don’t have to be ultra-conservative (although you should be more conservative than when you had years of work ahead of you).

Everyone’s different, and simple ‘stage of life’ rules and approaches based on your financial position ignore the key aspect of psychology. Those other factors have a part to play, though, and we’ll be tackling them next week.