Delivering a diversified stock portfolio

Investment Committee, Switzer Dividend Growth Fund
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The month of July is a natural time for investors to reflect on the performance of their portfolios. As the market starts a new financial year, accountants will be busy with tax reporting in the coming quarter.

While investors will review their portfolio returns they also need to address their appropriate (and realistic) expected returns, their true risk appetite (can you sleep at night?) and the time horizon. After all, defensives did what they were supposed to do over the past year (refer to Table 1 below for performance review of all markets and asset classes).

Of note, the average moderate investor risk appetite in Australia has a diversified portfolio across and within all the main asset classes.

The diversified approach

One of the aims for investors who have a conservative to moderate risk profile is to minimise the downside of their returns to assist with wealth accumulation over your life cycle. That is, meet realistic expected returns with a lower volatility versus the broader equity market. Clearly cash, fixed income and A-REITs performed well. International equities in Australian dollar terms also performed well, particularly US equities. The strategy of diversifying your earnings exposure in your equity portfolio worked well over the past year given that the local equity market has a bias towards local financials and resources.

To illustrate the benefits delivered by a diversified portfolio, Figure 1 shows the standard moderate investor profile asset allocation. This is a sample asset allocation that is sourced from our various Strategic Asset Allocation (SAA) benchmarks at UBS WM.

We have removed ‘Alternatives’ in this sample as we want to make it realistic for a self-managed super fund (SMSF). The one-year return to 30 June 2012 for this standard moderate portfolio was 3.79%, clearly a much better result than the broader equity market, with outperformance by double digits. Further, if an investor followed a core Australian equity strategy of dividend-seeking large cap stocks with a low beta target, the outperformance would be even higher.

Figure 1: Standard asset allocation for a moderate investor profile. This asset allocation is reflective in our UBS Wealth Management moderate investor profile, excluding alternatives.

Figure 2 shows the simulated historical performance of the sample moderate investor profile portfolio since 31 December 1987 through to 30 June 2012. The time period of historical financial crises are highlighted so we can clearly see the impact of each crisis.

The key of course is that volatility is a normal part of the market, while excessive volatility is not. Therefore a diversified portfolio that reflects your risk appetite generally meets your return expectations. Further, this portfolio has averaged an annualised return of 8.13% with annualised risk of 7.01% (which, in UBS’ view, is an acceptable level for a moderate investor profile).

For some additional perspective, the best calendar year performance was 25.76% in 1991 as the market began to price in the recovery from the recession of 1990-91. The worst calendar year performance was -18.19% in the 2008 GFC. While not a good outcome, it was a better return than the -40.3% return from Australian equities.

Figure 2: Simulated historical stress test of this sample moderate investor.

Note: The sample portfolio return simulation is based on the performance of the benchmarks referred to in Figure 1 above. The performance is based from 31 Dec 1987, includes total cumulative returns up until 30 June 2012.

This asset allocation assumes rebalancing of your portfolio on a monthly basis to reflect the proposed asset allocation benchmark weighting. Note that back testing the performance does not reflect the impact that past economic and market factors might have on investment decision making. There is no guarantee that the simulated past performance could, or would, have been achieved had this asset allocation been used during the years presented. Also, past performance is not indicative of future results.

In summary, we have aimed to highlight the basic concepts and building blocks regarding the ‘art of portfolio diversification’ through a diversified portfolio for an average moderate investor profile. It is quite clear that diversification across all the asset classes, and importantly within, are such key concepts that all investors need to be cognisant of it in their wealth accumulation.

Your asset allocation must reflect your return expectations, the amount of risk you employ (volatility) to meet your objectives and your time frame (which reflects your stage of your lifecycle).

Everyone will effectively need to explore their own bespoke SAA weighting benchmarks, as each person will have different requirements and risk appetites. It will probably differ to the weightings used in this note.

George Boubouras is the Head of Investment Strategy and Consulting, UBS Wealth Management Australia.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.

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