When it comes to investing money on financial markets, it is easy to get lost. As we strive to optimise our portfolios, we are exposed to a constant cascade of news which influences our thought processes and investment decisions. As a result, our portfolios may end up reflecting a rather uncoordinated compilation of investments rather than a well-diversified portfolio that was originally constructed with the goal of delivering the income or growth actually required to meet our needs.
Where to start?
The first important step in the investment process is to determine what our personal financial goals are. Before thinking about the investment strategy, we need to think about the target return – by how much we need our portfolio to grow in order to meet our future financial goals. At the same time, we also need to determine our risk tolerance – how much risk are we willing and able to take in exchange for potentially achieving higher returns? The answer to these questions is partly given by our individual investment horizon. An investor with a longer investment horizon is generally willing and able to tolerate a higher level of risk because cycles where returns are lower than desired can be endured while waiting for better times to come. In contrast, investors with a shorter time horizon tend to favour a lower risk portfolio as they would generally be less willing and able to withstand a bad spell.
Build an optimal portfolio
Investors are well advised to build a portfolio which achieves either the maximum return possible for a given level of risk, or which takes the minimum level of risk for a given target return. A portfolio which does this is known as an optimal or efficient portfolio. The concept of constructing an optimal portfolio is a cornerstone of modern portfolio theory and was introduced by the Nobel Laureate Harry Markowitz in 1952. All optimal portfolios build the so-called ‘efficient frontier’. In essence, an investor should aim to construct a portfolio of different asset classes which lies on this efficient frontier.
Why is the asset allocation decision so important?
Having clearly defined a target return and the willingness and ability to tolerate risk, what now? While the exact figure is debatable, it is widely believed that at least 80% of portfolio returns may be attributed to the portfolio’s asset allocation. Hence, determining what weight is allocated to each asset class is crucial. The dominance of the asset allocation decision relative to individual stock selection comes from the fact that different asset classes are not perfectly correlated i.e. their performance does not move up or down by the same amount and at the same time. Consequently, a portfolio benefits from investing across different asset classes, and through diversification within asset classes, an investor can optimise the portfolio’s risk-adjusted returns.
The cost of underinvesting in the long-term
Underinvesting hurts, even more so in a negative rate environment like the one we have today where cash has become a negative contributor to performance. Building an efficient portfolio (minimising the risk for a given expected return) is very important, but so is being invested sufficiently in risky assets because if the time horizon is long enough, then taking risk should pay off.
Portfolio management – rebalance regularly to stay on track
Having decided on and implemented the appropriate asset allocation given one’s risk and return targets, market movements will naturally cause the actual allocation to stray from the target allocation over time. Allowing the asset allocation to wander too far from the initial allocation decided upon would likely mean that the risk level and expected return of the portfolio are likewise drifting and no longer reflect those desired by the investor. Unless target return and/or risk tolerance changes, the logical course of action would be to bring the portfolio back in line regularly with the target allocation. This practice is referred to as rebalancing and should be considered frequently, at least once a year.
Asset allocation matters
The aim of a proper asset allocation is to select a combination of investments that has the highest likelihood of enabling us to meet our financial goals, while not exceeding the level of risk that we feel comfortable with. Investors should also be very mindful of the cost of underinvesting. Whilst diversification is key, it is also vital to remain disciplined and regularly rebalance the portfolio in order to ensure that the asset allocation serves the investment objectives.