What are the first steps to start a balanced investment portfolio on a low income?

Starting an investment portfolio can seem out of the realm of possibility for most when on a low income. However, when properly budgeted for and a regular savings plan created, over time, developing a significant investment portfolio is quite achievable.

Most individuals on low incomes believe that obtaining professional financial advice is not relevant to them, as they do not have significant assets available. Relatively however, these individuals are often able to obtain the greatest benefit from professional advice, as for them it could mean the difference of being able to afford to buy their own home, or to lead a more dignified retirement by being able to afford the basics and at least a few small luxuries.

So what is a balanced investment portfolio? A balanced investment portfolio has an even mix of income and growth assets. The income assets provide a steady flow of cash into the portfolio, which helps to smooth the volatility of the growth assets, while the growth assets provide capital growth, which over the long term will generally provide the majority of the returns to the portfolio.

It is important to mention that a balanced investment portfolio is not suitable for all investors. An analysis of each individuals risk profile, needs, goals and objectives, including their investment period is necessary to determine what asset allocation is most appropriate for them.

The steps described below form the basis of any sound investment plan. However, these may be especially pertinent to those on a low income due to the relative effect that effective budgeting and regular savings plans can have on those individuals.

Budget

The first step should definitely be to create a budget. A thorough budget will become the bedrock on which a stable and secure financial position is founded. If you’ve already got a budget, excellent, however it might be time for a review to see how you’ve done at sticking to it, and if it needs revising. Many people probably have at least a basic budget, and while something is better than nothing, completing a comprehensive budget is going to be the most beneficial. Budgeting is a whole subject on its own, and there are many useful publications on the matter, so I will focus on just a few main points.

Budgets need to be written down, a lose budget in your head isn’t going to cut it, a spread sheet, text document, or sheet of paper will work, there are even some great budgeting tools and apps available, including ASIC’s Money Smart Budget Planner.

All expenses need to be accounted for, you will be surprised how much all those small recurring costs add up to over a year, see the table below for an example of recurring costs that may be overlooked in the budgeting process.

Cost Yearly total
Netflix $13.99/month $167.88
Spotify $11.99/month $143.88
Hair cuts $50.00/month $600.00
Nails $30.00/month $360.00
Gym Membership $20.00/week $1,040.00
Coffee $5.00/day $1,825.00
Total $344.73/month $4,136.76

People often think that those small costs don’t matter enough to include in a budget, but as you can see in the example above, a person with these costs that neglected to include them in their budget could potentially blowout their budget by over $300 each month, or over $4000 in a year!

Expenses should be calculated based on actual costs rather than guessing. Also, anything that isn’t a fixed cost needs to be rounded up to account for things such as potential price increases, or unexpected costs such as extra work required on a car.

Include entertainment / discretionary expenditure in the budget. One point that many people fall down on when creating a budget is that they don’t allow for spending on entertainment and discretionary expenses for things such as, a night out with friends or a trip to the cinema. Neglecting to allow for these costs will inevitably lead to a blowout. Will power only lasts so long, and besides everyone needs a bit of fun, so make sure it’s budgeted for.

Budget for savings, commonly when creating a budget, the intention will be to save whatever is left at the end of the pay period rather than allotting a specified amount to savings. The error in this view is failing to take into account the human element. Seeing the money in your account can create the illusion of having extra disposable income and lead to overspending. Remove the temptation by moving your budgeted savings amount at the start of each pay period into a separate account, not linked to your bankcard.

Once established, a good budget will create a reserve of cash, which will help to cope with fluctuations in expenditure, negating the need for credit, the costs of which can be a major drain on finances. Conventionally, two months income is the ideal amount to have as a cash reserve, however, even one month or a fortnight in reserve is going to be beneficial, and will also reduce financial stress on those living paycheque to paycheque.

Probably the most overlooked, and potentially one of the most crucial, points when utilising an effective budget, is reviewing the budget. The budget needs to be reviewed periodically, or whenever a significant event occurs, such as a pay rise. Initially, I would recommend reviewing the budget monthly, however once the budget is well established and running smoothly, once every 3-4 months may be sufficient. The review process should include a review of expenses incurred over the period as opposed to what was budgeted then identifying areas where the budget has blown out and taking corrective action, by either rebalancing the budget or reducing spending in that area. This can be simplified if your banking provider allows for exporting your transaction history into a spreadsheet, or there are even applications that once set up will track your spending, such as the ASIC Money Smart App, TrackMySpend.

Develop Knowledge

A basic level of financial literacy is essential to any investor. It is important that you understand certain concepts in order to make informed decisions. There is a myriad of information relating to investments out there and one can easily become overwhelmed. Therefore, I have included a short explanation of some of the concepts that I believe all need to understand before making any decisions regarding investment. Please note this is not an exhaustive list, merely an introduction to a few concepts.

Risk Vs Return Trade off: this concept states that, as a general rule, the higher the projected potential return, the more it is likely to deviate from the projected return. The degree of likely deviation from projected return defines the risk level of the investment, so generally, the higher the projected return, the higher the risk.

Investment Asset Classes: All investments will fall into one of the asset classes, which can be subsequently broken down into one of many sub-classes. The different classes have differing characteristics, which can determine their appropriateness to different investors. The main investment asset classes are

  • Cash is an income asset and refers to deposits in bank accounts, term deposits and the like and generally accrue income interest payments. Cash is seen as the least risky asset class and generally offers the lowest return on investment.
  • Property, ownership of real estate, either directly or indirectly, which can generally be categorised as a growth asset, with the majority of return usually coming from capital growth of the asset. Property can also have an income component when rented or leased. Property can be sub-classified geographically, and by type (i.e. residential, commercial etc.)
  • Equities or shares are a proportional ownership in a company and are categorised as a growth asset, however shares that pay dividends also have an income component. Equities can be sub-classified geographically, by sector (i.e. mining, technology etc.), capitalisation (total number of shares outstanding multiplied by price per share), and by whether they generally pay dividends.
  • Fixed Income are income assets as they generally provide the investor with a fixed amount of income (as the name suggests) as well as the return of the initial investment at a designated time in the future. Fixed income assets include bonds (Government and Corporate), and futures.
  • Alternatives are assets that don’t fall into the other classes and include; hedge funds, Artworks, Stamps & Coins, and Infrastructure. Property is sometimes considered an alternative class asset. Attractive alternative asset investments will usually have either a weak, inverse, or no correlation to the other investment classes. This means that movements in traditional investment markets, such as the stock exchange have either little, the opposite, or no effect on the returns of alternative assets. For example, a contraction of the stock market is likely to have little effect on the value of artworks or collectable coins.

Liquidity: This refers to how quickly and easily an asset can be sold down and returned to the investor as cash. Assets such as equities and fixed income are usually considered to have high liquidity, whereas property and alternatives are generally ill-liquid

Diversification: Ever heard the saying “never put all your eggs in the same basket”? That’s what diversification is. The more individual investments you spread your capital over, and the less each individual investment is correlated to the other investments in the portfolio the greater the diversification. I.e. investment in various asset classes, sectors, geographical regions etc. As an example, buying two identical units in the same apartment complex will provide little to no diversification, buying a unit in an apartment complex and a retail store in another geographical location would be more diverse, and investing in managed funds with underlying investments in all asset classes, across various sectors, and geographical locations would provide a greater level of diversification. Increased diversification reduces the risk across the portfolio when compared to an undiversified portfolio with a similar projected return.

Develop and Implement a Strategy

When developing an investment strategy for individuals on a low income, it’s likely that they may lack a significant initial deposit. Therefore, an ongoing contribution plan is likely to form part of the strategy. In the first step I recommended creating a budget as a starting point, and including an allotment for savings within. If this is done well, the contributions to the investment will be sufficient to outweigh the ongoing costs of the investment and keep the portfolio ticking along, however not so high as to cause financial stress on the individuals and have them needing to drawdown on the investment.

Many are drawn to the idea of property investment, potentially due to the physical nature of bricks and mortar and the perception that they could lose everything investing in the stock market. In the case of individuals on low incomes, I would argue that direct property investment would likely be unsuitable for most, and that a well-diversified portfolio of equities has almost no chance of becoming worthless. There are large costs involved in purchasing property, finance would likely be required, which they may not be able to secure. The fact that the entire investment is tied up in a single asset means that there is no diversification, and that in the event that a drawdown from the investment were required, it may be necessary to sell the property, in which case significant costs would be incurred.

Alternatively, an investment through a Separately Managed Account (SMA) or Wrap Account generally will incur lower initial and ongoing costs, can offer a superior degree of diversification, and will generally have low or no initial and ongoing investment requirements. These types of accounts are a platform through which investments in listed securities and managed funds can be made. For those on a low income, costs are likely to be of paramount importance. For that reason, investment through this style of platform if potentially the most suitable option.

Since these platforms have access to listed securities, it would be possible to invest in low cost, diversified investment options known as Exchange Traded Funds (ETFs). ETFs are listed on stock exchanges and are investment funds that have underlying investments based on the rules of the ETF. These ETFs can track a single index, or have investment allocations based on certain criteria. Because these products are based on rules, they are easily managed and therefore are generally cheaper than other investment funds. They offer a high amount of diversification, an ETF following the S&P500 will give an investor instant exposure to the 500 biggest companies in the world. They are highly liquid, since they are traded on an exchange, they can be readily cashed in or purchased, unlike a traditional managed fund, which can take a significant amount of time to buy into or cash out of. These ETF’s are likely a suitable investment option for those on a low income as they offer a high quality, liquid investment with low costs.

Another consideration would be whether to invest through superannuation. Salary sacrificing is not as beneficial for those in lower tax brackets, however government co-contributions for those on low incomes do make the option more enticing. It is extremely important to consider the investment period for individuals considering superannuation investment as the money will be locked away until they reach preservation age, or meet a condition of release, so potentially until they reach the age of 65.

Review

While the topic was regarding starting an investment, the review process is crucial. The review process involves assessing the return of the portfolio over the period, whether or not the strategy continues to be appropriate for the individual, as well as rebalancing the profile if required. Assessing the return of the portfolio as a whole, and that of the individual investments, will allow the investor to know how they are tracking in relation to their goals and whether their goals need adjusting, or a change to the asset mix needs to be made. Throughout the year, differences in returns from assets, and income will cause the investment portfolio to become imbalanced. Therefore, periodic action will be required to return the asset allocation to the desired levels.  This review process needs to be carried out regularly, say every 6-12 months.

The above represents a basic outline of the process of establishing an investment portfolio, with consideration of those on low incomes and suitable to a balanced asset allocation. With the help of a qualified Financial Planner, the process can be extremely simplified and streamlined for the investor. As would be expected, the use of a qualified Financial Planner would also likely result in a better outcome for the investor.

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