Truth be told most of us want double-digit returns on our investments each year, and we don’t ever want to lose money. And in our naive way we try to achieve this aim by randomly choosing fast-moving stocks, blindly following trends and generally taking on too much risk. When we don’t earn double digit returns we are disappointed; and when we lose money we are mortified.

People do not build houses by randomly plonking bricks next to each other. Houses are carefully built on architectural plans that determine such things as the floor layout, or the relationship between rooms, walls and doors. Similarly, professionals construct investment portfolios using a plan that takes into consideration important features such as an individual’s age, attitude to risk, investment timeframe, existing assets, income, tax rate, investment goals and so on. As the well-worn saying goes, ‘if you fail to plan, you plan to fail.’

Your investment horizon

Your investment plan must be specific to your goals and personality, as well as your investment timeframe. An architect doesn’t design the same house for a family of six, as he does for a childless professional couple. Similarly, a 35-year old should not have the same investment strategy as a 65-year old; or a person planning to take up full-time study next year will have a different investment strategy to one that plans to work full-time for the next 20 years.

You need to determine the time available to build up your assets. If you intend to work full time until retirement, how many years away is that? Or maybe you’d like to set up your own business one day, requiring you to save for start-up costs. When will you need to turn your investments into cash?

Your attitude to risk

Most investors mistakenly believe that they’re risk takers. It’s common for people to choose the ‘high growth’ category on super forms – when in reality, a 20 per cent fall in their investments, sending their portfolio from $100,000 to $80,000 or lower, would cause them considerable stress. High-risk investors are those who can handle a 20 per cent fall without raising a sweat.

As mentioned earlier, your risk tolerance is also tied to the following:

-    Investment timeframe - when will you need to convert your investments into cash?
-     Your age - do you intend to work full-time for the foreseeable future, or will you be retiring soon?
-    Your goals – is wealth accumulation important to you? Or do you prefer a set and forget investment strategy?

Your risk tolerance is also linked to your existing assets and debt. If you are already geared to the hilt on a property purchase, then taking on more risk across your remaining portfolio may take you way out of your risk tolerance level.

Asset Allocation

The reason for thinking through the above points first is that it’s a prerequisite to step two, and that’s investment selection. Where should you invest? Most of us head directly to the sharemarket for answers – weighing up whether BHP is a better bet than NAB. 

Instead, we should firstly consider the range of asset classes available, which include domestic and international shares, direct and listed property, fixed interest, and cash. And depending upon our risk profile, we should ideally allocate a percentage of our money across each of these asset classes.

Below are examples from Securitor of four different portfolios ranging from high risk to conservative, with some telling statistics that highlight the upside and downside of taking on extra risk. These examples are for illustrative purposes only.

High Growth – for a timeframe of 10 years and over

Source: Securitor

The High Growth portfolio invests entirely in shares and property in an effort to maximise returns. The portfolio could potentially make returns in the high thirties in a bumper year, or tumble by as much as 14 per cent in a market downturn.

Growth Portfolio - for a timeframe of 7 years and over

The Growth Portfolio has an 82 per cent allocation to shares and property, but spares 18 per cent of its money for cash and fixed interest investments. Due to its high allocation to growth assets, this portfolio could make as much as 30 per cent in a bull market but could also tumble by as much as 10 per cent in a downturn.

Balanced Portfolio – for a timeframe of 5 years and over

Moving down the risk spectrum, the balanced portfolio has a 68 per cent allocation to shares and property and a 32 per cent allocation to fixed interest and cash. Due to its lower-risk profile, portfolio returns are unlikely to ever exceed 30 per cent (the best you could get is around 25 per cent), but you’re compensated by the security of knowing that the portfolio shouldn’t lose more than 7 per cent in a downturn.

Moderate Portfolio – for a timeframe of 4 years and over

Further down the risk spectrum there’s the Moderate portfolio. These investors face a much smaller 6 per cent chance of losing money, which would only impact the portfolio by about 3 per cent, on average (taking 6 months to make it back). But the portfolio’s returns are less exciting – forecasted between -3% and 19% in any given year.

Defensive Portfolio – for a timeframe of 3 years and above

The defensive portfolio is unlikely to lose money in any given year. But investors trade off this security with lower returns – which could rarely exceed 14 per cent, even in a cracking year.

The above exercise is a handy way to ascertain your preference for security, set against high returns. Some of you will be tempted by the chance to receive 30 per cent or more on your money, even against the backdrop of possibly losing 14 per cent of your savings in any one year.

Others will be completely turned off by the thought of losing money – regardless of the returns that could be made.

Monitoring your asset allocation

Once you've determined which asset allocation you believe best suits you, unfortunately it’s not a matter of simply dividing your capital between the asset classes and being done with it. As markets boom and stagnate, your asset allocation will move accordingly. For instance, following a bull market in equities you’ll find that your allocation to equities will be much higher than bonds, for instance. So, if you want to retain the same risk level it may be advisable to realign your portfolio every three years or so – by selling down overweighted assets.

Other factors that change over time are your investment goals, and even risk tolerance. As you become more educated about investing and the sharemarket you may feel that you want to lift your weighting towards shares to accommodate more risk.

This column provides general information on investing, rather than specific financial advice. Readers should not imply any recommendations from this column. Do further research or consult a licensed financial adviser before acting on information in this column.