How Do You Build An Investment Portfolio?

We are often asked, How Do You Build An Investment Portfolio? by clients. Portfolio construction can be deeply theoretical and mathematically complex, limited only by the range of statistical measures and metrics being employed at the time. There is also sadly no silver-bullet solution to creating a portfolio and each asset managers approach will be different, with portfolios constructed in aim of achieving a set of goals; some of which may be production of alpha (positive returns above that of a corresponding benchmark or index), robustness and protection against drawdown (periods of negative performance) or non-variant returns (a consistent return-profile, often the hallmark of an ‘absolute return’ strategy that seeks to mitigate tail risk).

Often we will start with a target annual rate of return, a time horizon and a risk budget (i.e how much capital are we willing to explicitly put at risk in aim of achieving our performance target). This will allow us to then proceed to choose appropriate asset classes and specific instruments within these asset classes. Investors are often preoccupied with the when? and at what price? of investing and this behavioral bias will detract from time spent calculating appropriate asset allocations. One study suggests that more than 91.5% of a portfolio’s return is attributable to its mix of asset classes. In this study, individual stock selection and market timing accounted for less than 7% of a diversified portfolio’s return.

With this in mind, performance attribution will for better or for worse be inextricably linked to asset allocation. A good portfolio will maximise return for a given level of risk. This risk/return tradeoff is at the core of Modern Portfolio Theory- parts of which are integral to our own construction process. For those new to investment it is an alien concept that risk is neither good or bad in a binary sense and is simply a component in the investment process that needs be managed to achieve investment objectives. If you accept no risk, you will also have to accept having no returns. We would encourage you to actively budget risk in line with your investment objectives and monitor your portfolio, dynamically re-adjusting when your allocations move away from your original design.

Thinking in terms of, and assigning a “risk premium” (the reward we are given, by way of returns, for taking on risk) across instruments and asset classes will allow us to model and make objective decisions at portfolio level. The basis of this requires us to know the “risk free rate of return” to use as a yardstick for comparison. In our case we use a basket of medium-dated government issued fixed interest securities (which have the perceived lowest risk in the asset universe). Thereafter, we are able to compare an instrument to our hypothetical risk-free instrument and equate how well we are compensated for taking on risk; thus allowing us to spend our risk-budget judiciously.

For government bonds we assess the “term premium” today in relation to its long run averages. For corporate bonds, we incorporate the so-called “credit risk premium” (the likelihood that the company will be unable to pay back its obligation to bond holders and default). For equities, we incorporate a measure of the “equity risk premium”, which we measure using a version of the dividend discount model (predicting future dividend payments and discounting them back to present value, in line with inflation to arrive at an estimation of value). Looking at each asset class discreetly allows us to create a more robust portfolio and avoids the behavioral bias of purchasing assets based solely on historical performance.

To reiterate, there is no right or wrong answer. In our book, a quality portfolio will produce consistent growth, with modest drawdowns during periods of market stress, with sufficient liquidity to satisfy short-term capital requirements. We would also recommend an amount of skepticism, in spite of good net performance, if this has been achieved at the cost of inappropriate asset allocation. By way of an example, Portfolio A could produce 12% p.a for 5 consecutive years and Portfolio B could produce 6% for 5 consecutive years. In the sixth year, if Portfolio A is, through poor asset allocation, victim to large volatility -and Portfolio B is not- then the previous 5 years of steady growth could be removed instantaneously from Portfolio A and Portfolio B will outperform. This is a concept known as variance drain. Consistent mindfulness of your objectives and your own risk-tolerance are the tenets of creating a good portfolio and will allow you to invest intelligently without compromising your risk budget or your sleep.

 

[Sources]

– Harry Markowitz, The Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pp. 77-91. “Portfolio Selection”
– Gary P. Brinson, L. Randolph Hood, Gilbert L. Beebower, Financial Analysts Journal July/August 1986 | Vol. 42 | No. 4 | “Determinants Of Portfolio Performance”
– Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, Financial Analysts Journal, Volume 47, Issue 3, Determinants of Portfolio Performance II: An Update

Latest Insights

Summary
How Do You Build An Investment Portfolio?
Article Name
How Do You Build An Investment Portfolio?
Description
How do I pick investments? How do I build a portfolio?
Author
Back to Top
Close