Have you always been comfortable with shares?
I certainly haven’t. Like most people, for years I thought the sharemarket was this crazy place consisting largely of two types of people.
- Professional traders yelling at each other and pulling their hair out.
- Individual traders AKA those twitchy screen-refreshers who anxiously watch every tick up and down, hoping one of their stocks goes to the moon and they’ll get rich.
Because it was (and still is) rarely shown, there was no indication to me that you could simply be a quiet owner, building up stakes in lots of businesses and collecting some of their profits via dividend payments.
But when I stumbled upon this delightfully sensible (even boring) way to invest, everything started making a lot more sense. The sharemarket became far more attractive as a place for my savings, despite its ups and downs.
As you can tell, there’s been a journey rather than a fixed position. This is what I’d like to discuss in this meaty article.
How much should you allocate to shares? Should it change over time? What are the alternatives, and what does that look like?
We’ll discuss assessing your own risk tolerance and how you might use that to put together a portfolio. We’ll also delve into how it’s different for retirees than working folks, and some other ways to diversify your wealth and income that you might not be thinking about.
Let’s dive in.
Is an all-share portfolio the best approach?
Once we understand the sharemarket, building our portfolio becomes fun. We start enjoying the process, buying more shares and seeing our dividends come in.
At this point, when our portfolio is small (and especially if the market is going up), it’s common to think: “This is awesome, I just want to own shares and nothing else.”
You’re confident in the fact that shares will perform well over the long term and you definitely don’t want to have money laying around earning less than it could potentially earn in the market.
But then things change. Over the years, your portfolio gets bigger. Now those downward movements start to hurt a little more. Volatility isn’t so scary when your $15,000 portfolio drops to $10,000. But a drop from $150,000 to $100,000 is a bit different.
The percentages are the same, but the perception changes. It feels different somehow. So while the market is doing exactly the same thing, your pain level is likely to be higher. We’re human, not computers… so we feel losses in dollar terms, not percentages.
Is this irrational? Many would say yes. But I say, not really. A loss of $5,000 is easier to ‘get back’ than $50,000. This is because it represents a smaller amount relative to our income, our expenses, and every other dollar figure in our life.
So even though drops in our portfolio may be temporary, as our wealth grows, the psychological comfort and enjoyment of an all-share portfolio starts to weaken. Not for all of us, but more than a few!
How to assess your risk tolerance
Because of how our minds perceive losses, we might want to come up with a tailored approach to our portfolio. What’s comfortable for one person may be stressful for another. So how do we figure that out?
Think about your current portfolio, whatever size it may be. How would you feel if it went down 20%? What about 40%? What does that look like in dollar terms?
Try your best to imagine how you might feel in such a scenario. And remember, markets fall because of a worsening outlook. So the real life situation will be far more uncertain and potentially worrying than just the numbers alone.
Find the level of downturn where you’d feel a little sick. That’s probably your maximum tolerance level. If there’s a level of loss where you may tap out – “I can’t do this anymore” – then you’re taking too much risk.
But maybe you’ve experienced a sharp fall in share prices before (I’m talking 30% or more, not 5-10%!). If you have, reflect on how you handled that experience. Were you cool as a cucumber? If so, maybe an all-share portfolio (or your current approach) is just fine. Or were you a little jittery?
Here’s the thing: having 100% of your net worth in the sharemarket might sound great on paper. But in reality, not that many people have the stomach for it. Despite what you hear from enthusiasts (like myself and others) about getting more invested to reap more long-term gains, having an ‘all-in’ approach is certainly not suitable for everyone.
As cliched as it sounds, there really isn't one size fits all. Our portfolio and financial plan really does need to be tailored to our own situation and psychology. Now let’s talk about those on the more nervous end of the spectrum. If someone decides the volatility from an all-share portfolio may keep them up at night, they might want to diversify their portfolio further.
What happens with a more diversified portfolio?
“Wait, I have a diversified portfolio – I’m invested in companies from all over the world.”
An investor can be perfectly diversified within shares as an asset class, yet not be diversified across their wealth. Their investing outcomes rely solely on the fortune of businesses and markets as a whole. And just like with a share portfolio, some are totally happy with this approach, while others not so much. I’m not saying there’s anything wrong with that, but it’s worth being aware of.
As we’ve discussed, given shares are a volatile asset class, adding other assets can dampen down some of the inevitable fluctuations and smooth out the ride. Most of the time, this means sacrificing potential upside for a more limited downside. And for many of us, that’s a tradeoff we’re happy to accept.
So while a more diversified portfolio can mean lower long term returns, that’s not always the case. It depends on a couple of key things, which we’ll discuss in the next two sections.
What are the expected returns of other assets in your portfolio?
Okay, so what else could we add to dampen down the volatility of an all-share portfolio?
Lots of stuff! Here’s a few ideas…
- Cash
- Bonds
- Peer-to-peer lending
- Residential property
- Commercial property
- Private business (buy one or start your own)
Cash and bonds are essentially stable and solid (cash more so). With these two, people will tell you how much upside you’re missing out on. But in the next section, I’ll explain why that may not really be true.
Now yes, many of these assets still fluctuate in price. The difference is, their volatility is typically lower than the share market. What’s more, any price changes aren’t visible because you aren’t auctioning these assets every damn day of the week. That makes owning them a bit more relaxing.
Mentioning private business might sound odd, but hear me out. A small business will not have a value you can see all the time, making it much more likely you'll just hold onto it. You can also increase the value of it over time as you build the income of the business. This value is redeemable later if the business is sold. So while unusual, I still thought it was worth mentioning. Others may suggest gold and precious metals are a good diversifier also, despite their lack of income.
Overall, your wealth may still be volatile. But adding other assets such as the above will smooth out the ride in most cases. From the options, you simply pick whichever is the most natural and appealing fit for you.
Now, depending on who you ask, some of these assets might be considered higher risk than a share portfolio. There’s an argument for that. But the conversation in this moment is not one of risk, but of expected returns, psychological comfort and visible volatility.
Is an individual property riskier than a diversified ETF? Probably. But how is an investor’s commitment and confidence changed by adding an asset they feel comfortable with? Especially when that asset is more stable in price, often moves separately to their share portfolio, and the value isn’t slammed in their face everyday.
The truth is, where mindset is involved, perception and emotions matter. Things are very different in practice than in theory.
How does the extra diversification affect your behaviour?
If you’re investing in other assets with expected returns that may match or even exceed the share market, then you may not actually end up with a lower return.
So the question is: How could having a blend of assets impact your psychology? Quite easily. If the volatility of an all-share portfolio makes you nervous enough to sell at the wrong time, or hold off making your regular investments, then it’s actually costing you in returns.
Because of this accidental self-sabotage, you will not get the market returns you’re hoping for. And certainly less than someone who’s truly comfortable with the same portfolio who’s able to keep investing right through the pain.
So if being less invested (by having cash or other assets) helps you sleep well at night, you’ll be far more comfortable during downturns, even to the point you buy more than you otherwise would.
This has the effect of improving your returns, despite the supposed ‘sub-optimal’ choice of not being fully invested. And you may even outperform the Nervous Nelly who stubbornly tries to stay fully invested but can’t quite stomach it.
So both of these factors – expected return of other assets, and how your behaviour is affected – influence to what extent you actually get lower returns by having a more varied blend of assets. That difference may turn out to be very small or even non-existent!
Alternatives to an all-share portfolio
If you’ve decided that an all-share portfolio isn’t for you, there are plenty of portfolio variations you could create. The below are just some random examples I’ve made up.
Our personal portfolios will consist of not just assets that fit our risk tolerance, but investments that we’re actually interested in and attracted to. The fact is, some of us just like the traits of certain asset classes more than others.
Conservative:
- Shares: 50%
- Bonds: 30%
- Cash: 15%
-
P2P lending: 5%
Middle of the road:
- Shares: 50%
- Residential property: 20%
- Commercial property: 15%
-
Cash: 15%
High growth:
- Shares: 40%
- Residential property: 20%
- Commercial property: 15%
- Private business: 25%
The labels and percentages here are, of course, arbitrary. And yes, the ‘high growth’ investor may still keep some cash on hand for expenses and so on. But I wanted to highlight what a fully-invested alternative might look like instead of all-shares.
After an investor decides to shift from all-shares, an alternate portfolio would likely be something they work towards, rather than putting their money into each month. Because with extremely lumpy investments such as property and businesses, it’s simply not feasible to buy these assets directly in an incremental fashion. However, the investor can still create a long term target which meets their overall goals, risk appetite and interests.
Other considerations
Time horizon
The longer you’re investing for, the more easily you should be able to ignore the short-term movements. All else being equal, a 10-year investor will be more anxious facing losses than a 40-year investor.
Your time horizon determines your reliance on current market conditions. A longer time horizon gives you a greater ability to move towards an all-share portfolio. Sitting through a downturn can suck, but knowing you've got decades to recover can make it much easier. On the flipside, anyone who plans to sell up in 10 years or less needs to carefully consider how aggressively they're invested.
But it also depends how flexible you’re willing to be. If I was pulling money out of the market in five years, and couldn’t afford to wait longer (AKA I needed to sell), then I definitely wouldn’t invest in an all-share portfolio. I might very well keep it in a boring (but thankfully now decent-returning) savings account!
Home ownership
This one’s easy to forget. If you’re a homeowner (or plan to be), then you'll always have part of your wealth that isn’t fully correlated with the sharemarket.
While it may not be on your radar, this gives you an extra piece of optionality that an all-share investor doesn’t have. You could sell this asset at any time in the future and redeem your equity to do as you please. Granted, few will do that, but it’s still an option worth keeping in the back of your mind.
Housing in Australia seems likely to perform well over the long run. And while there are significant costs involved in ownership, it does eventually save you from paying rent each week. Combine that with some capital growth and you’ve got a reasonably good return on the money tied up in a paid off home.
Revisit this yearly
Once a year, check in with how your portfolio is going. How are you handling the fluctuations? Because remember, as the dollars get bigger, it’ll start to feel different.
Ask yourself: is this level of aggressiveness still right for my situation? Am I comfortable with these moves and still able to focus on the long term? Or would I rather accept a lower long-term return for a smoother ride? Are these the assets I still want to invest in based on my goals? Or does adding something else make sense?
As with most things in life, it's all about tradeoffs and priorities. Only you know the answer to these questions.
In retirement
Things change when you begin living off the portfolio you’ve built. Those who are now more reliant on the portfolio may feel the market’s movements more acutely.
How can we deal with this? Well, in addition to the other ideas above of diversifying a portfolio and using cash as a backstop to ‘top up’ income or to avoid selling during a downturn, there’s another idea I want to mention: Part-time income.
Now sure, you’re not really reducing the volatility of your wealth. But you are greatly reducing the volatility of your income, and greatly reducing your reliability on market conditions, which is extremely useful. It doesn’t even have to be much work. Even one day per week (say $10,000 a year) may be able to cover 20% of your expenses.
Basically, anything that makes you more independent of market prices or investment performance is useful. It makes your situation stronger and more adaptable, giving a huge mental boost.
Final thoughts
The percentage you allocate to shares may decrease as your wealth grows, even as the dollar figures increase. So you can simultaneously have more money instead in shares while being also less reliant on those shares. That’s an interesting concept in itself.
But if you have no interest in other asset classes, or the sometimes brutal volatility of shares doesn’t bother you, then maybe you opt for and stick with an all-share portfolio. As I’ve said, you’ll need to tailor the portfolio to suit your personal goals and risk tolerance, which will likely shift over time too.
So think about your situation and whether an all-share portfolio is right for your psychology, or whether a more conservative or blended portfolio might suit you better.
At the end of the day, getting comfortable with the volatility of your wealth is about psychology, not numbers.
Until next time, happy long-term investing!
Dave
