What does a good asset allocation for passive income look like?

Welcome to Finance and Fury, The Say What Wednesday Edition. 

Where each week we answer a question from you.

Hi Louis,

I have a questions about portfolio construction and asset allocation. I am 36 years old and am trying to understand what is the most appropriate asset allocation to have. There is so much material out by I am looking to build a portfolio that is skewed towards reliable income paying stocks through dividends even in down times and hence have favoured the larger Aussies LICs and ETFs. I am 100% in equities with 80% Aussies Shares (LICs and ETFs) and 20% international (ETFs US and Non US) however trying to understand what does a good portfolio and asset class look like and what are the things I should be further considering. I am looking to maybe add Gold (direct through direct ownership and Gold ETFs) and Bonds as I keep hearing these are good to have for assist in downtime but the income on these are very poor but then also thinking should I be having more international exposure / alternative asset classes like A-REITS/ emerging markets etc however as mentioned I am more focused on ongoing incoming paying stocks. 

Would love to hear your overall high-level thoughts and views. Thanks, Mario  

Three steps – Investing between asset classes – Investing within an asset class 

Finding the right investments to fill them

Asset classes and correlation –

Few things to cover off here

The ideal weighting of Asset allocations is important – Three questions to help determine this:

1. It depends on the purpose of the investment portfolio. What do you need to achieve?
   1. Long term growth – Trying to maximise the balance
   2. Short term stability – Well diversified portfolio with low exposure to growth
   3. Drawing an income or reinvesting – Type of investment held
2. How much time you have?
   1. Longer timeframes allow for more planning and take advantage of the long term growth
   2. Being 36 and assuming you won’t need this for 20+ years, the volatility
3. And how much risk you need?
   1. Returns come in two parts = Income + Growth
   2. If there is growth to the equation, it can lose value – Enter risk – But it can help long term
   3. Bonds – do provide some incomes but yields are low due to higher prices –

Portfolio construction –

What you need to know for achieving needs – Three more questions from this

1. What asset classes you need and how much of each you will need?
2. What investments within each will you need?

First) Asset Classes – Selecting the correct mix of Income and Growth

1. Go through five big ones – Core to most portfolios (Doesn’t include direct property)
   1. They can be broken down to their purpose – Example – If you need to draw a consistent income, you won’t want much volatility
2. Asset classes – No growth – Low chance of capital loss (Defensive)
   1. Cash – Interest
   2. Fixed Interest – Coupon payments (FV back at the maturity)
      1. Debt instruments – not all bonds – higher-yielding such as notes but the higher yield is paid due to risks
3. Asset Classes – Growth – Has a chance of capital loss (Growth)
   1. Australian Shares – Dividends and Price gains (Generally higher Dividends than International shares)
   2. International Shares – smaller dividends and Price gains
   3. Listed Property and Infrastructure – Dividends and Price gains – but more volatility and leveraging risks

Second) How to determine the allocation to each class?

The traditional way – Risk Profiles (Outlines but remember, not perfect) – But if income is the goal – focus on asset classes which have more income – Australian Shares

1. High Growth – 100% to Growth – Longer-term 8+ years
2. Growth – 80% to growth – Longer-Term – 7+ years
   1. Cash, FI of 20%

Third) Selecting the allocation to each asset class

Even though something is defensive it can be income focused.

1. Defensive – Generally for either income or capital protection
   1. Cash – How much income do you need? Need for reserves?
   2. Fixed Interest – Australian or International. Credit, alternatives or Bonds
      1. Higher risk (Corporate debt) – higher yields
2. Growth
   1. Australian Shares – Market caps – Selecting a good weighting between asset classes – focus on higher Div paying shares
      1. ASX50 – Large Cap allocation
      2. Small-cap ETFs – Issue is when they are passive
      3. Income paying investments – can focus on higher Div paying/high yield ETFs
      4. ETFs – VAS = 4.1%, VHY = 5.3% but 7.3% grossed up
   2. International Shares – Countries and Market Cap of countries – some countries don’t pay dividends like Aus
      1. Van USA = 1.8% yield – Int Index = 2.4% yield – Average fixed interest index pays higher – Aus FI 3.8%

The aim of each asset allocation: Trying to do a balancing act to determine your risk tolerance

1. Risk – Volatility – Potential movements in price around a mean average
   1. High potential for movements, considered higher risk
   2. Speculative risk – Can become absolute risk (i.e. losing everything) but can be avoided (Diversification – the whole point of asset allocation) – could buy a few shares that payout 7% Dividend, but volatility may be a killer of returns
2. Income Focus of returns – want more Div paying companies-
   1. So might be overweight to Aus FF shares – while being underweight to USA lower div paying companies

Back to the Question: Ideal Weighting for an income focus

– general information only – not advice as haven’t taken personal situation into account

1. What is the purpose, timeframe and return needed?
   1. Purpose is to invest to generate a passive income while trying to minimise volatility
      1. You want to achieve a better income return than cash
      2. Allocation – Growth – about 80% Between shares and infrastructure –
      3. 20% bonds/fixed interest – pays higher incomes that US ETF
      4. Alternatives like gold while providing diversification and capital stability – no income so may not be appropriate

2. What to watch out for?
   1. REITS – leverage and income payments can come from capital gains – which dry up in downtimes
   2. Large Caps – Mostly Banks/Financials picking up the slack – their incomes may struggle over the next few years
   3. Emerging markets – Likely volatile and may not pay out incomes
   4. Yield trap – prices that drop can reflect a higher yield – without the dividend being paid
      1. Example – $100 share, $5 div = 5% yield – price drops to $50, looks like 10% yield – but may be a reflection of future income losses
         
         
3. Finding the right investments –
   1. ETF structure – flow-through of returns – take what you get, so selecting correct underlying holdings is important
   2. LICs – not flow through dividends – but selected dividends like any normal company – can work in your favour for stability but at expense of growth as gains are reinvested but can be paid out
   3. Select what yields you are after 5-6% – make sure they are high quality

Thanks for listening to today’s episode. 

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