A conversation about portfolio construction begins with investment methodology. Sound methodology should be based upon historical and statistical investment facts that are timeless. Everything that is included in a portfolio should be there for a specific and merited reason. Here’s how to properly construct a long-term growth portfolio.
1.) Start with an equity bias.
Simply stated, because of the long term return potential, the portfolio needs to have more equity investments than debt investments. The chart below displays the stark difference between the long-term performance of equities (blue and red lines) and debt (gold and silver lines).
*The chart shown is for hypothetical and for illustrative purposes only
2.) Diversify into multiple asset classes.
Diversification reduces risk and increases return, therefore increasing risk adjusted return. The chart below shows 20 years of asset class performance. Follow the orange Foreign Stocks box, located at the bottom left corner, through the 20 year period. The performance tends to be either at the top of the chart or the bottom, which indicates that the asset class is volatile. The point of diversifying is to reduce the volatility of an individual asset class by combing it with other classes. The white box entitled “diversified portfolio” demonstrates a smooth and upward trend line that is the hallmark of a consistent portfolio.
Building on the diversification chart above, the chart below shows how combining individual asset classes helps to decrease risk and increase return. (Notice the arrow pointing to portfolio ABCD, which is comprised of all four asset classes. Now find portfolio AB, which is comprised of only U.S. and Non U.S. stock. Many investors have a portfolio that looks like AB. They think that they are properly diversified because they have U.S. and International Investments, but they are actually barely diversified at all.)
3.) Know that Correlations are why Multiple Asset Class Diversification Works.
In order to build an optimal portfolio, examine the correlations between each asset class, which explain how they react to each other. For example, bonds generally react oppositely of stocks, so if stocks go up, bonds go down, which shows as a negative correlation on the chart below. A properly constructed portfolio will have asset classes that hold low correlations to other asset classes, like Natural Resources, Real Estate, and Bonds. These assets will produce a better risk adjusted return, helping to provide a higher ceiling and floor for the portfolio. (Notice how the traditional equity investments, U.S. and International stock, are highly correlated. This explains why the portfolio above, AB, was not well diversified.)
*The correlations shown are hypothetical and for illustrative purposes only
4.) Build the portfolio.
Using the guidelines discussed above, build a portfolio. Below is a sample, notice that it has an equity bias, as roughly 80% of the portfolio is invested in equities. It’s also properly diversified and built with respect to asset correlations, as there are 6 asset classes represented, including Natural Resources, Real Estate, and Bonds.
*The portfolio shown is hypothetical and for illustrative purposes only
5.) Maintain and rebalance the portfolio.
Portfolios that are left alone will change their character as time goes on, fundamentally changing the makeup of the portfolio and increasing the risk. In order to prevent this from happening, make sure that original portfolio’s allocation (as seen in the chart above) stays the same from year to year.
6.) Test the methodology.
Testing the sample portfolio against the S&P reveals that the investment methodology made a significant difference. To put it numerically, properly building and maintaining the sample portfolio made a $6 million difference to the bottom line. (Back-testing is not foolproof, but it does illustrate how the various asset classes behave in relation to each other. Reports like this one could be run for virtually any 10+ year time period and the result would be a similar performance for the diversified portfolio. This reveals a key lesson. It’s not the specific investment choices that make the difference, it’s the asset class choices.)
*The portfolio performance shown is hypothetical and for illustrative purposes only.
Tags: Investment Management