Vera Lin, Ord Minnett

This year has compounded the income problem as the financial impact from COVID-19 has seen a cashflow squeeze on companies, greatly reducing their ability to maintain or increase dividends. 

A low-income portfolio return early in retirement can have a long-lasting impact on future income. Consequently, retirees may be driven to chase yield up the risk spectrum to try to preserve the same level of income. 

Before taking on excessive risk in your retirement fund, it might be useful to know that a critical component of portfolio construction, and a major determinant of risk and return in any portfolio over time, is adhering to an appropriate asset allocation on a regular basis. 

The concept of maximising returns while minimising risk might sound straightforward, but there is a methodical process to attaining an “efficient frontier” in the portfolio. 

To achieve true diversification, there would need to be an optimal exposure to different asset classes in Australian equities, international equities, fixed-income securities, cash and alternatives. 

If we drill down further, there would likewise be a discerning split between different sectors of healthcare, technology, industrials, utilities, financials, mining, energy and other sectors. 

Growth assets, such as Australian and international equities, small-cap shares, and emerging markets, generate long-term capital growth to protect against inflation, low interest rates and longevity risk. 

Defensive assets, such as bonds, bank hybrids, term deposits and cash, provide liquidity to help match regular drawdowns and reduce overall volatility in the portfolio. 

This plays a key role in tackling sequencing risk [the timing and order of returns] for retirees which prevents the need to sell down growth assets in a share market downturn to meet drawdown obligations. All the while, a main determinant of each exposure is uniquely based on the individual retiree’s risk profile.

Rebalancing the asset allocation of a portfolio may feel emotionally counter-intuitive at times, but a diligent investor will sell down growth assets (such as shares) in a bull market and buy growth assets during market stress. 

The primary goal of this strategy is to maintain an appropriate risk exposure in the portfolio to generate better risk-adjusted returns in an expanding and contracting sharemarket. 

It can help manage downside risk during a market sell-off, in part due to the capital-preservation qualities in the portfolio, and it can also enhance risk-adjusted returns over time by allowing for better repositioning of stocks, sectors and asset classes into the recovery period.

Unfortunately, retirees may no longer be able to rely on traditional investments to solve their income problem, but rather a careful combination of dynamic strategies to future-proof their retirement.

A statement we hear too often from retirees is: “I have funds to invest into the market and I am looking at investing into the four banks as they will always pay me an income and will continue to grow”. 

Regrettably, the unprecedented times of 2020 have proven this theory wrong. If the investor followed through with that investment model, his or her capital would be significantly reduced and income almost non-existent. 

This example reinforces the importance of diversification when investing in the sharemarket and retirees developing a personal investment strategy for their fund. A strategy tailored to their individual needs, objectives and outcomes, as well as considering the most appropriate asset allocation for their risk profile.

When considering an appropriate investment strategy, a good starting point is the “Sleep at Night Factor”. That is, how much risk are you comfortable taking on to achieve the desired investment and income result? 

The objective of a diversified portfolio is to establish the level of trade-off between risk and return you are comfortable with. 

Each asset type has a different risk-and-return profile and each portfolio should apportion a percentage weighting to these asset classes, dependent on the risk profile of the retiree. 

The main asset classes are:

• Cash – zero risk and return
• Fixed interest – lower risk and low return
• Australian equities – higher risk and expected return
• International equities – as above
• Property – both listed and unlisted have a large range of risk and return.

Each asset class will typically have different economic and market triggers, so when volatility is present, having a diversified portfolio will smooth out the impact on a portfolio’s valuation. 

In essence, the asset classes are not perfectly correlated to each other and hence will move in alternate directions, depending on the volatility at the time. For example, when equities fall, fixed-interest investments will generally rise.

Another statement commonly heard from retirees is: “All I care about are dividends and franking credits”. Although that is a fair statement, the total return on a portfolio is the sum of:

• Dividends
  
• Franking credits, and 
• Capital growth.

While each part of the above contributes to overall return, it is important to recognise point three, where capital growth on a holding can be realised when appropriate and used to pay an income stream. 

Given most retirees are generally tax-free on all or most of their funds, this will not have a tax effect. Additionally, they are not drawing down on the capital invested, but are utilising the profits (capital gains) from that investment to generate the income required. 

The March correction has attracted many new investors to the sharemarket as they look to take advantage of depressed prices, in many cases while they are working from home under various lockdown restrictions in some States. 

The Australian Securities and Investments Commission (ASIC) conducted a study after witnessing increased activity from retail investors and a change in trading behaviour in March and April. 

The study highlighted the failures of new investors in trying to pick individual stocks and timing the market for short-term trades rather than investing for the long term. Retail traders have traditionally performed poorly, even under less volatile sharemarket conditions.

One such way to remove the risk of picking individual companies is via diversification. 

Diversification entails spreading your investments across a range of companies or asset classes such as shares or bonds, geographic regions and industry sectors. 

A simple and cost-effective way to achieve diversification in your portfolio is through Exchange Traded Funds (ETFs). 

(Editor’s note: The free ASX online course on ETFs is a great way to learn about their features, benefits and risks.)

An ETF can be made up of hundreds of companies the average investor could not normally afford to buy as individual stocks. The increased popularity of ETF’s have seen ETF providers create funds that follow more than just the broader market index. 

ETFs are now available that track a specific region or sector, such as energy, technology, banks or commodities. Using sector ETFs can be an advantageous strategy to gain diversified exposure to sectors that are performing well in the current environment or those expected to recover as the world returns to normal post COVID -19.

This approach removes the risk of picking individual companies and is also more conducive to long-term, wealth-creation strategy.