Portfolio of Assets
After you identified and documented your goals and objectives (Investment Policy Statement), the next step is to build a portfolio of assets to achieve your goals. Any investment (including the portfolio that you’re going to build) is created with risk and reward in mind. The aim of investment professionals is to create a portfolio that provides the highest return for the least amount of risk.
Risk is measured by the Standard Deviation (“SD”) of the returns. Return is self-explanatory: it’s what you earn through dividends or capital gain from your investment. So if we plot a graph with risk (or Standard Deviation) on the X axis and Return on the Y axis, and consider any possible scenario, we will have a graph labeled “Efficient Frontier” in the chart below. Any risk/return combination that is to the right of the efficient frontier is inefficient.
The next step is to graph CAL, which is the ‘capital allocation line’. The equation for this line is the basic linear equation: Y = a + b * X, whereas in this equation, a is risk-free rate (so the intercept on the Y axis is risk-free rate), and b is Sharpe Ratio and X is the standard deviation of the return on the portfolio. This is a complicated concept and it’s only presented here for the purpose of familiarity with the concept. Our goal is for you to be aware that there is some mathematical basis for selecting different types of assets within a portfolio.
In terms of selecting the class of assets, there are some simple ways for allocation as well. For example, for the longest time, it was recommended to younger investors to construct a portfolio of 60% stock and 40% bonds. There is another rule which works based on your age. Subtract your age from 100, and the number you get is the % you allocate to stocks. For example, if you’re 30 years old, you allocate 70% to stocks (100 - 30 = 70) and the remaining amount to bonds (30%). However, given the very low returns on bonds after the financial crisis of 2008, the 30% in the above example is usually split between different classes of assets.
If you consider actively managing your portfolio, you should be aware of the following factors: 1) are you accurately forecasting the stock performances, 2) do you take action on your forecast, and 3) are you seeing tangible results? In finance, we have fancy names for any of the three items, namely: Information Coefficient (signal quality), Transfer Coefficient (Portfolio Construction), and Added Value (Realized Active Returns). Basically, these are the three legs of a triangle.