SMSF Investing Education & Strategies

A step by step SMSF investment process

Probably one of the most important issues in the world of DIY / Self Managed Superannuation is the ability of SMSF trustees to create and implement a well defined, well thought out, prudent investment strategy for their Fund. 

Sounds simple enough, but the most common mistake is that investors tend to look straight to what specific investments they want to make (e.g. which shares do i buy) instead of starting with a more broad based 'top down' approach which enables a range of factors to be considered before you get to the actual investment selection. This type of approach will help provide you with an outcome that is more in tune with your overall objectives & risk comfort zone, and lowers the overall probability of you blowing up your SMSF.

 

The steps below take you through just such an approach, and is designed to give you a good chance of implementing a prudent investment strategy that is in line with your objectives and risk tolerance. You will find this also dovetails into the requirements of the SIS act, where you need to formulate and give effect to a written investment strategy for your SMSF that takes into account a number of specific factors listed in the SIS Act and Regulations. More information on those conditions, plus a sample written investment strategy template is provided at the Investment Strategy template page.

 

Step 1. Define your overall investment objectives:

This sounds obvious and is indeed quite straightforward, but is often missed out by trustees or they are too vague. It is also very important as it will have a large impact on your asset allocation (which you'll find out below has the most impact on your investment returns) and your individual investment selection. Your overall objective will be closely linked to what stage of life your at, what stage your SMSF is at (accumulation or pension), and what the cashflow requirements are for the fund (such a pensions payments).

For example, the objective for a younger person with 25 years to go until retirement might be to grow their capital as much as possible over those years, within a moderate to high volatility tolerance (see Step 2), with no specific cashflow requirements other than to pay for the expenses of the fund, and will aim for a total long term annual target return of say 12% pa. On the other hand, the objective for a retiree may be to preserve capital as much as possible whilst providing enough income cashflow to sustain their pension payments for the next 20 or so years, within a low risk / volatility tolerance, and a long term annual target return of 7%pa. See the stark difference ? Suffice to say, the investment mix of these two investors would be quite different.

 

Step 2. Identify your own personal level of risk & volatility tolerance:

Volatility relates to the amount that the price of an investment asset changes (both up and down) over a given time frame, and relates directly to the risk of your SMSF balance falling in value. Your personal 'volatility tolerance' is how far can your overall portfolio fall in value over a given time frame that you can financially and emotionally handle. Whilst this will generally be different for members based on their stage of life, it can also differ from person to person in the same stage of life. There is a general perception that just because a member is relatively young, that they should be mostly or totally invested in the 'growth' or 'risk' asset classes such as shares and property. However, this is simply not always the case. Everyone is an individual, and just because an asset class like shares shows a higher long term general return than say cash (although it does depend on your definition of 'long term' and what time frame you choose), this doesn't mean that every individual is willing to accept the much higher volatility that comes with it.

 

Now there are a couple of ways of stating your volatility tolerance. There is the fairly generic method of saying you have either a high, moderate, or low tolerance. The other way is be more number specific, and say for example that over any financial year, you cannot accept a fall in portfolio value of anything more than say 10% etc. This method will require you to be fairly specific with your assumptions on how far you think a particular asset class or group of investments could fall in any one year. The actual risk you take on & the volatility you can expect will be a function of your Asset Allocation and how you invest within each asset class, which we discuss below.

Step 3. Set your Asset Allocation based on matching your objectives with your risk / volatility tolerance

This is where the rubber starts to hit the road. Asset Allocation refers to what percentage of your portfolio you invest into the various asset classes such as Shares, Property, Fixed Interest, Cash, etc. There have been many academic studies done over the years that conclude up to 80% of your total return is actually explained by your asset allocation, rather than your individual investment selection. As each asset class has a historical set of return and volatility characteristics, it allows you to set an asset allocation that gives you a reasonable expectation of fulfilling your overall investment objectives (as stated in Step 1), yet constrained by your tolerance for volatility (as stated in Step 2).

 

The first concept to understand is that some asset classes have higher return potential and hence have higher risk or volatility than others. Therefore, the more of your SMSF you have invested in the higher growth/risk asset classes, the more risk and volatility you can expect from your overall portfolio. The order of volatility from highest to lowest is:

 

Forex & Derivatives (due mainly to their leveraged nature)
Shares (including listed property trusts)
Direct Property & Collectable's (longer periods between re-valuations)
Fixed Interest
Cash

 

And this is where you may need a reality check when matching your objectives (in Step 1) with your risk/volatility tolerance (in Step 2). If, using our example, you are the younger person wanting a long term growth rate of say 12%+pa, but you simply cannot tolerate any risk or volatility in your portfolio, then you have a mismatch. No risk or volatility implies being mainly invested in Cash and Fixed Interest, which historically will get you mid to low single digit returns. So you will have to make a decision - which is more important you. Higher potential returns, but you have to accept higher risk, moderate potential returns with moderate risk, or low returns and no to low risk. And this is where your Asset Allocation sets the boundaries.

See our Asset Allocation page for examples on how to go about matching investment objectives with risk & volatility tolerance, and coming up with a sensible asset allocation target. This page also includes information on 'static' versus 'dynamic' asset allocation.

 

Step 4. Then, within each asset class :

(a) What type of investment will be used

For example, in Shares, will you prefer to use a managed shares fund, or will you invest directly in individual shares, or will you just invest in the index via an Exchange Traded Fund (ETF). Further to this, will you use derivatives, such as options, futures, CFD's etc. It might be a combination of some or all of these. Also remember this links back in with your volatility tolerance parameters in Step 2. Derivatives (due to their leveraged nature) will be more volatile than direct shares, which will in turn generally be more volatile than an index ETF or fund.

 

(b) Limit 'permanent loss' risk by mainly investing in high quality assets with sufficient liquidity

The main problem with low quality investments is the probability of 'permanent' capital loss due to the entire investment disappearing, and/or defaulting on income payments, or where you just cant sell it due to there being no buyers (illiquidity).

For example, in the Shares asset class, compare a very small low priced (1c) speculative mining exploration stock with a big blue chip miner like BHP. The 1c stock may have a good story, and only needs to go up by 1c to double your money. However, it is also running out of money, hasn't found any minerals, cant get finance, and there is virtually no bidding in the market for the stock (and hence no liquidity if you want to sell out). Very high risk, because there is a high probability is that it is not going to be around much longer, and the illiquidity means you cant sell your holdings if you want to. BHP on the other hand has high quality assets and lots of cashflow, and is considered a blue chip investment. It will of course still go through a lot of price volatility based on general market movements, and the fluctuating price of commodities, but there is an enormous amount of buying and selling of the stock (i.e liquidity) in the market so you can sell your holdings without a problem.

So as a general prudent rule of thumb, choose predominantly high quality assets in your SMSF with low risk of 'permanent capital loss', and with sufficient liquidity if you need to sell. In the Shares asset class, this will mean fundamentally strong companies will strong balance sheets, good business models, and with sufficient size and market liquidity if you need to sell out quickly, rather than micro cap speculative, illiquid stocks. For Fixed interest, this will mean Government bonds, bank term deposits, and highly rated corporate bonds rather than low grade corporate bonds or other non-rated fixed interest products. For Derivatives and Forex, it means using stop losses and keeping your leverage to a low to modest level. And if you decide you still want some exposure to the high risk end of the spectrum for the potential high returns they may provide, keep it limited to a small portion of your fund in the event they turn into a ' permanent loss'.

 

(c) What tool, strategy, or process is used to select (and subsequently sell) individual investments

For example, if your strategy in the Australian Shares asset class is to buy a portfolio of individual shares, what is the selection criteria for each purchase and sale ? Are you using an investment newsletter, a broker recommendation, fundamental analysis software, technical analysis software, or some other specific method uch as "value investing" ? It may well be a combination of methods. Articulate what this is going to be and make sure it makes logical sense and that each method has some sort of track record to refer to. Don't just invest blind. You'll find this may change a bit over time, and is really at the very pointy end of your investing.

 

Step 5. Ongoing regular review

Set a timeframe to which you will regularly come back and review the structure of your investment strategy e.g. every 3 months, or 6 months etc. We are not talking about individual investments here. They can be overseen on a daily basis (i.e. the sharemarket can change rapidly) and changed at any time that a buy or sell criteria is met. We are talking here about adjustments to the overall structure e.g. you may decide over time to change your asset allocation if your moving from working to retirement, or your changing your method of choosing shares, or you want to include a new asset class etc etc. Of course you can also do this at any time, but at least set a time frame to which you will definitely look at it and review.

 

Step 6. Keep learning and enjoy the process

Investment markets are a lifelong learning process. Even the most seasoned campaigner will learn new things as markets evolve and times change. If investing for your SMSF becomes onerous, frustrating, and a boring chore, you might as well hand it back to a fund manager and do something else you enjoy. Keep an open mind, and enjoy the continued learning experience, and your results will probably thank you for it.