Clients sometimes ask us how we built the Stockspot portfolios, and why we selected 5 assets to invest in rather than 2, 3 or 10!
It comes down to the purpose of the Stockspot portfolios which is to maximise returns for each level of risk. Five assets allows us to give clients the best possible combination of returns, risk and costs.
To do this we leverage the benefits of diversification. Diversification simply means that by combining investments with different characteristics you can improve the quality of returns in your portfolio.
Quality of returns is measured by how much risk you need to take to earn a certain return. Since all investing involves taking some risk, the aim is to minimise the risk you need to take to earn the return you want. Diversification across assets enables you to take less risk to earn better returns.
Let’s start with a investment portfolio of 100% Australian shares. Assuming it’s a balanced portfolio with, say 25 stocks across different sectors, you’re likely to earn a return of about 10% per year over the long term. Great right? Well… not really.
The risk of that investment portfolio (measured by standard deviation of returns) is about 16% per year. That means you can expect your portfolio to go up or down by about 1% per day! That’s not so awesome.
Bonds are beautiful…
Now let’s say you add a second asset – bonds. This is where the benefits of diversification start to kick in.
Based on a portfolio of 80% shares and 20% bonds you can expect to earn a return of about 9% per year – with risk of about 13%. Compared to the 100% shares portfolio it means you’re sacrificing about 1% per year in returns but getting a benefit of 3% less risk!
This is a more efficient investment portfolio because you take on significantly less risk and don’t need to give up much return.
Five is the magic number
Now let’s look at the benefit of adding 3 more asset classes to Australian shares and bonds. The 3 other assets included in the Stockspot core portfolios are global shares, emerging market shares and gold.
By adding these 3 assets to the investment portfolio, expected returns improve by 0.5% to 1.0% per year based on the same level of risk as portfolio of only Australian shares and bonds. Higher returns without higher risk is the magic of diversification. It’s possible because the 5 assets tend to move in different directions – this helps to smooth the portfolio peaks and troughs.
The point is, you can never eliminate risk from your investment portfolio, but diversification adds safety and reduces the risk of a ‘portfolio fatality’.
Beyond the 5 assets it is difficult to improve a portfolio further especially when you incorporate transaction costs. Our analysis suggests that adding more assets could increase returns by a small amount per year, but the benefit would be eroded entirely by the additional transaction costs needed to periodically rebalance those additional investments.
We believe that the 5 asset Stockspot core portfolios offer the best possible balance of risk, reward and cost for our clients. We recently published the 4-year performance of the portfolios and it’s clear they provide a much smoother path than just owning Australian shares.
We continue to research other asset classes that could be added in a low-cost way to improve the quality of returns in our core portfolios. For clients who invest more than $50,000, we now also offer a selection of investment themes which can be added for additional diversification benefits.
A note on small accounts
Stockspot accounts can be as small at $2,000, which doesn’t always provide enough cash for a meaningful exposure to the 5 asset classes. Therefore for small accounts we use a process of gradual optimisation to add ETFs that best match the expected performance of the target portfolio allocation while minimising the “drag” from any uninvested cash.
This process typically results in portfolios with a smaller number of asset classes, but similar historical performance to the target core portfolio. As these accounts grow in size they automatically transition towards our typical 5 asset portfolio allocations.
Grow your savings the smart way
Stockspot is Australia’s largest and most experienced online investment adviser. We make investing easy and affordable. Whether you’re growing your wealth, saving for a home, a family or retirement, we help you do it with the right investment portfolio and guidance.
Main image: edupov via Flickr
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This article was originally posted in June 2016 and has been re-published in November 2018.