When it comes to investing money in financial markets, it is easy to lose your way. 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 can end up reflecting a rather uncoordinated compilation of investments rather than a well-diversified portfolio that has been carefully constructed with the goal of delivering the income or growth required to actually meet our needs.
Where to start?
The first important step in the investment process is to determine what your financial goals are. Before thinking about your investment strategy, think about your target return – by how much you need your portfolio to grow in order to meet your future financial goals. You also need to consider your risk tolerance – how much risk are you willing and able to take in exchange for potentially achieving higher returns? The answer to these questions is partly influenced by your time horizon. An investor with a longer time 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 the 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 shortly before they want to realise their assets.
Build an optimal portfolio
Investors should look 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 your target return and your willingness and ability to tolerate risk, what now? While the exact figure is debatable and depends on your point of view, it is widely believed that at least 80 per cent of your portfolio returns can be attributed to the portfolio’s asset allocation and therefore determining what proportion of your wealth is invested into each asset class is crucial. The dominance of the asset allocation decision relative to individual stock selection is based on 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.
No matter how much research has been done, the one certainty in life is the existence of uncertainty and consequently there will be risks inherent in any investment, albeit more in some than others. If an investor were to split their eggs between many different baskets, losing one basket completely (e.g. if the value of one particular equity falls to zero) would have a relatively small impact. In terms of investing, this translates into allocating portions of your portfolio to different asset classes. Historically, different asset classes have not been perfectly correlated. Through diversification an investor can reduce the risk taken and the overall portfolio return is likely to be less volatile.
The cost of underinvesting in the long term
With all this talk of lowering risk, it is important to remember that a portfolio would also suffer from not taking enough risk. Building an efficient portfolio (minimising the risk for a given expected return) is very important, but so is investing in sufficient risky assets because, if the time horizon is long enough, then taking risk should pay off.
Rebalance regularly to stay on track
Having decided on and implemented the appropriate asset allocation given your risk and return targets, market movements will naturally cause the actual allocation to stray from the target allocation over time. Unless your target return and/or risk tolerance changes, the logical course of action would be to regularly bring the portfolio back in line with the target allocation. This practice is known as rebalancing and should be considered frequently, at least once a year.
Rebalancing can be done in different ways: by selling assets that are currently overweight and buying assets that are currently underweight with the proceeds; by putting more money in and buying only investments in the currently underweight asset classes; or if making regular contributions to the portfolio, directing more of these to investments in the underweight asset classes.
Don't loose sight of the long-term goals
In a scenario where an investor’s equity allocation has increased due to strong performance, while other asset classes have drifted below their target allocation due to poor performance, investors may be hesitant to sell equities and buy asset classes that have performed less well. 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.
The aim is to select a combination of investments that has the highest likelihood of enabling you to meet your financial goals, while not exceeding the level of risk that you feel comfortable with. Investors should also be very mindful of the cost of underinvesting. Diversification is key and it is also vital to remain disciplined and regularly rebalance the portfolio in order to ensure that the asset allocation stays broadly in line with the defined target allocation.