Portfolio Construction and Asset Allocation
“ The wages of sin is death but by the time taxes are
taken out, it’s more of just a tired feeling." Paula Pounstone
Building A Portfolio
Everyone know that building a well performing investment portfolio consists of much more than just buying a multitude of investment vehicles and hoping for the best. Today we all hear phrases such as “modern portfolio theory”, asset allocation, diversification, cross correlation and rebalancing.
This newsletter seeks to not only define some of the above mentioned terms but to bring some fundamental understanding of why good investment portfolios are constructed as they are.
Modern Portfolio Theory
Modern portfolio theory has shifted investor’s attention from individual securities to a consideration of the portfolio as a whole. The emphasis is on two primary items: risk and return. Of course every investor wants to maximize their portfolio return, but they want to do so only at an acceptable level of risk. Hence the term a “risk adjust portfolio”.
Asset Allocation
But how do we maximize returns while minimizing risk? The answer lies in taking an asset allocation approach to portfolio construction.
First some definitions: diversification can be thought of as using different kinds of investment vehicles. Asset allocation, however; not only uses different investment vehicles but purposely combines different vehicles in an investment portfolio that react differently under various market conditions.
Simply put, if diversification says “don’t put all of your eggs in one basket”, asset allocation says “don’t put all of your eggs in one basket and use different kinds of baskets”.
Cross Correlation
So how do we “use different kinds of baskets when constructing an investment portfolio? The answer lies with correlation coefficients. A perfect positive correlation between different assets is a value of 1. A perfect negative correlation is a value of -1. When constructing investment portfolios, professionals try to utilize asset classes with small to negative correlations. That is, we use assets that don’t all act the same way under specific market conditions.
A Landmark Study
A financial analyst named Roger Gibson conducted an exhaustive study designed to answer the question: Who are the entities in America that control the largest sums of money and how do these entities invest their portfolios? Brinson found that the large national pension funds of states and corporations were the entities with the largest sums of money. So, he looked at 100 of the largest pension funds over a 10 year period. He found that he could statistically attribute the investment performance of these funds to three things: (1) superior security selection, (2) market timing and (3) asset allocation. But here’s the interesting thing, asset allocation accounted for over 90% of the investment returns.
An Example
Now that I’ve thoroughly confused you or put you to sleep, let’s see in an example will help explain the concept.
Let’s say that you want to build an investment portfolio consisting of just two asset classes and the asset classes you will use are large cap stocks and treasury bonds because they’re negatively correlated. (They don’t act the same way under the same market conditions.) You allocate 70% to stocks and 30% to bonds. As the year goes by, let’s say the market does extremely well so that at the end of the year you now have 90% in stocks and only 10% in bonds.
What the big pension funds would do in this case and how they make their money is to now rebalance the portfolio. That is you take your profits in stocks by selling some of them to bring the allocation back down to 70% and utilize that money to buy treasury bonds to bring their allocation back up to 30%.
What your investing discipline has now forced you to do is sell high and buy low. These pension funds do this over and over and over again and consequently have some of the best performance in the nation when it comes to investing in the market.
Risk Adjusted Portfolios
Portfolio risk can be measured by utilizing a statistical measure called standard deviation. Basically, the higher the standard deviation, the higher the risk associated with that portfolio. Or put another way, the higher the standard deviation, the greater the probability that the investment results will deviate from the expected return.
It seems counter-intuitive, but we can reduce overall risk in a portfolio by adding a riskier asset class to that portfolio so long as the added asset class has low or negative correlation to the rest of that portfolio’s asset class constituents.
Additionally, portfolio risk is affected by the basic percentage of portfolio assets that are allocated to stocks, bonds and cash. Stocks historically have the highest return of the above mentioned asset classes but also have the highest risk associated with them.
By skewing a portfolio towards stocks we can expect a higher return and a corresponding higher level of risk. Conversley by skewing the portfolio towards bonds, we can expect a lower return and a corresponding lower level of risk.
Each portfolio I manage is a risk-adjusted portfolio based on the risk tolerance of the individual portfolio owner.
In Summary
As you can see, building an intelligent portfolio takes a significant amount of thought. It’s easy to build a portfolio consisting of only two asset classes, but when including 8 or 10 different asset classes, it takes a computer to analyze the cross-correlations between the constituents.
Moreover, the decision needs to be made as to the basic allocation between stock, bonds and cash and the rebalancing frequency.
Finally, we know that over the long term, markets go up because capitalism works; we just have no clue as to the precise short-term path of the markets.
Invitation
If you’re not a client yet, and you’d like to explore the option of developing a professionally managed investment portfolio comprised of no-load mutual funds, please give me a call.
I’d be happy to sit down with you and explain how as a fee-only investment advisor I can assist you in meeting your financial goals.
Marshall Sitarik - CFP
Ph. 407-977-3800
Marshall@MyCFP.net