Portfolio Construction Considerations

Now that we’ve discussed the goal of asset allocation, the classic asset classes and return considerations as well as the risks involved, it’s time to put it all together. A portfolio is essentially the entire holding of your assets. The portfolio itself is a culmination of the assets and usually exhibits different characteristics to the underlying assets themselves. This is especially true when the portfolio is well diversified.

Generally the process starts with determining what kind of returns you need to target according to your unique requirements and situation. This will help determine the asset classes to be included in the portfolio and the amount of money (weighting) in each asset class.

Diversification between assets within these asset classes then takes place in order to reduce non-systematic (business) risk. As time progresses the portfolio will need rebalancing as one or more asset classes in the portfolio outperform the others.

Probably the most important concept when it comes to constructing a portfolio is diversification. Let us consider two investors who have gone through the process of determining which returns they need to target. Both need an allocation to the income component (fixed income) of 40% and 60% allocation to capital gains (equity).

The first investor creates a portfolio as follows:

  • 40% in a single 10 year government bond

  • 60% in a single stock

The second investor creates a portfolio as follows:

  • 40% across 10 different bonds

  • 60% across 20 different stocks

Although both investors have exactly the same asset class weights of 40% fixed income and 60% equity. The first investor carries significantly higher risk than the second. For example, if the single stock the first investor is invested in goes bankrupt then the investor could potentially lose 60% of the entire portfolio.

This is not the case with the second investor because if 1 stock of their 20 stock equity allocation goes bankrupt, the potential loss of the second investor is significantly less than the first. This signifies the importance of diversification.

Asset Class Weightings

As you can imagine there are essentially an infinite amount of ways in which asset classes can be weighted in a portfolio. Fortunately there are a couple of techniques that can be used to help start you off in the right direction.

The classic 60/40 split

This asset allocation offers a simple rule to follow by investing 60% of the portfolio in stocks and the remainder 40% in fixed income. Exactly the same as the example above. This allocation is considered pretty well balanced with the majority of the portfolio geared towards capital gains and the remainder to the income component.

Note: Please remember that both the capital gain component and income component exist within the equity and fixed income asset classes to a certain extent. It’s just that equity has a greater capital gain potential than fixed income, and fixed income has greater income potential than equity in general.

The one issue with the classic 60/40 split is that it may not be appropriate for those who require a very conservative asset allocation (less equity and more fixed income) for whatever reason. It generally works quite well if you have a long-term (more than 5 years) investment horizon and do not foresee the need to use money from the portfolio within the short-term (less than 3 years).

120 minus your age

This is another simple allocation rule where the allocation to equity is determined by subtracting your age from 120. So if you are 30 years old, your allocation to equity would be 90% (120 – 30). There’s a lot to be said for this allocation method since as we progress in age we generally need less capital gain and more income to maintain our standard of living. This is especially true once we reach retirement.

1/N rule

Probably the most intuitive approach to asset allocation is splitting the portfolio evenly across asset classes. So if you’d like to invest into equity, fixed income, commodities and real-estate you would simply put 25% (¼) of the portfolio into each.

Although very simple, the allocation is generally considered quite naive as you may not benefit from greater capital gain potential (by only having 25% in equity) and may be inappropriately over-allocated to a volatile asset like real-estate. Therefore although intuitive, it does come with potential dangers.

Relationships Between Asset Classes

We have explored the importance of diversification within asset classes above. The next concept to understand is how asset classes behave in relation to one another, and the subsequent effect on the total portfolio. This leads to the concept of correlation.

Correlation, in terms of investing, is defined as the extent to which two assets move relative to one another. It is represented as a number between +1 and -1. If two assets have a correlation of +1 it means their returns move in the exact same way. A correlation of 0 means the returns of the two assets have no relationship at all. While a correlation of -1 means the returns of the two assets move exactly in the opposite direction to one another.

Note: correlation does not take into account the size of the returns. It rather compares the direction of the returns (positive or negative) to one another. For example, if asset A and B have a correlation of exactly +1, and asset A has a return of -10%, you cannot say asset B will have a return of -10%. You can only say that asset B will also have a negative return.

The more uncorrelated assets you add to a portfolio, the lower the volatility of the portfolio. Volatility is akin to standard deviation and is used in portfolio risk analysis. In a general sense, the more volatile a portfolio the more risk it carries. While diversification helps mitigate the non-systematic (business) risk, adding uncorrelated assets (or assets with low correlation to one another) can help keep portfolio returns consistent over time.

Correlation is dynamic and changes over time. There are periods in history that show that the correlation between equity and fixed income have been both positive, zero and negative. The astute investor may be able to interpret these changing correlations and put them to use, since a changing relationship between asset classes may signify an investment opportunity elsewhere.

For the rest of us though, it’s prudent to keep an eye on the correlations between asset classes in your portfolio to ensure that the portfolio maintains an acceptable level of volatility.

Note: volatility is not a bad thing, in fact without it it would be near impossible to achieve financial success. This is because asset prices generally need to change in value in order to profit from holding them. The trick is to make sure that volatility works for you and not against you.

Next: Maintaining the Portfolio

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