In this article equily co-founder Helen Lawton, discusses her approach to portfolio construction, including the concept of re-balancing.

There are two approaches to portfolio construction:

Portfolio Construction Approach 1: Bottom-Up

A bottom-up approach involves selecting individual firms, and your overall portfolio exposure to asset classes, countries, industries etc. is just a by-product of those initial selections. You are more likely to end up with a bottom-up approach to portfolio construction if you are using an active management investment approach.

Explainer: Active Investment Management
Active investment management is an investment style where finance professionals use their skills and expertise to manage a fund that aims to produce higher returns than a simple index-tracking passive fund. For example, you can buy a (passive) S&P 500 index-tracking ETF with an annual management fee of around 0.05% (with the fund’s hidden trading costs adding another few basis points to the annual cost), whereas the annual management charge for active funds is often around 1%, and often with high hidden costs because actively managed funds tend to do a greater amount of trading than passive funds.

Can the extra costs of active management be justified? In recent decades there has been a lot of academic research (see Part 4) showing that active managers do not outperform passive indices after accounting for costs and risk. It is hard to correctly predict the future – be sceptical of fund managers who think they can. And be sceptical of your own ability to predict the future, or your ability to pick the best active fund managers.

Portfolio Construction Approach 2: Top-Down

A top-down approach to portfolio construction means firstly deciding your overall allocation to the asset classes (equities, bonds, alternatives and cash). Your percentage allocation to equities is a good indicator of your overall portfolio risk. And the existence of allocations to multiple asset classes (equities, bonds, alternatives) in your portfolio is the first step in diversifying your portfolio. The second step is diversifying as much as possible within each asset class. For example, you decide whether to put all your equity allocation into one fund that tracks the world stock market (then US equities will be a very large share of your equity allocation – around 60%) or whether you can be more diversified and, for example, put 30% of your equity allocation into each of developed Europe, North America and Asia Pacific (totalling 90%), and 10% into emerging markets.

Explainer: Passive Investment Management
Passive investment management is an investment style where finance professionals manage a fund that aims to track a particular index, usually by buying the constituent members of that index. Most passive investment funds weight the constituent members of their fund according to market capitalisation (market cap). A company’s market capitalisation is calculated by multiplying the company’s total number of traded shares by its present share price. For example, you can buy an ETF that tracks the UK’s FTSE 100 index. There are two main index providers in the world, the MSCI and FTSE Russell, who provide (among other things) equity, fixed income (bonds), and real estate indices. Nearly all passive index tracking funds are based on indices from either the MSCI or the FTSE Russell.

Diversification and Risk

“Diversification is the only free lunch in finance”
Attributed to Harry Markowitz, Founder of Modern Portfolio Theory

The overall risk of a portfolio depends on (i) the proportion of risky assets (equities) to less risky assets (bonds); and (ii) the level of diversification in the portfolio.

The higher the proportion of equities you hold in your portfolio, the higher your expected returns, but also the higher your risk of losses. A 70% (and above) allocation to equities would be considered high risk, and a 30% allocation (and below) would be considered low risk.

Risk is the expected variation in the returns of an individual asset or an overall investment portfolio. Risk is commonly measured using the standard deviation of returns of an asset. The global equity market has a standard deviation of around 20% a year, and it is a little higher for emerging markets and a little lower for developed countries. Equities are higher risk but offer higher returns than safer investments such as cash and bonds, and this holds whether you hold equities for weeks or decades. Over the long-term equities are likely to outperform cash and bonds. But equities are also more likely than less risky investments to experience a deep sell-off (and hence a large reduction in value) during the time you own them. Bonds are less risky, although their individual risk depends on their issuer and maturity. The Vanguard Global Bond Index Fund has a standard deviation of around 5% a year.

High Returns vs Risk
It is not possible to buy an investment where you can expect high returns for low risk, no such thing exists. The higher the return you expect to make, the higher the level of risk you will also have to take. The only way to improve your expected return for a given level of risk (e.g. having decided to invest 70% of your portfolio in equities and 30% in bonds) is by diversifying your portfolio. Diversification lowers risk. In a diversified portfolio, individual investments have low correlations with each other. And there is no such thing as a risk-free investment. Even cash is not risk-free because inflation erodes the value of cash over time.

Correlation of Different Asset Types

Correlation is a way of measuring the similarity of returns for two assets. If the assets in your portfolio are very similar then it will be riskier because the returns of these assets will rise and fall together – so during a market crisis, these assets will fall together. Assets with low correlations will not all fall together during a market crisis, making your portfolio less risky. And for assets with a negative correlation (historically, equities and bonds are negatively correlated), the returns of one will rise when the returns of the other falls in value, further reducing the riskiness of your portfolio.

A highly diversified portfolio contains investments from the three asset classes – equities and bonds spread across many countries, and alternative investments such as real estate and gold. Note that spreading your equities and bonds over many countries which aren’t perfectly correlated, will be less risky than concentrating your equities and bonds in any individual country. Also, if you put 100% of your portfolio into equities you will be missing out on diversification.

If you are buying an equity index fund weighted by market capitalisation, then small caps (small companies, another source of diversification) will be under-represented. It may be worth buying an additional fund for a specific region / country that tracks the relevant index of small cap stocks.

Rebalancing

A portfolio will need rebalancing because over time individual investments will drift away from their original allocations. This changes the risk and diversification profile of a portfolio. A portfolio will also need rebalancing if there is a change in the investor’s risk preference, or if a new/better/cheaper fund comes along and it is worth substituting for an existing fund. The primary purpose of rebalancing is to manage risk and diversification, rather than maximise return, but rebalancing should improve risk-adjusted returns.

When the overall value of a portfolio changes, note it is only relative price changes that matter for rebalancing. If the price of every investment in the portfolio has halved, then the original weighting for each investment would remain unchanged and rebalancing would not be necessary.  Portfolios also need to be rebalanced if there is a build-up of cash dividends, or if you are contributing or withdrawing cash lump sums from your portfolio. There are costs to rebalancing – you can use any cash dividends and contributions/withdrawals to rebalance more cheaply.

Many investment platforms will reinvest cash dividends for you (either for free or a small fee) but you need to consider whether any fee is good value. If the fee is 50% of the value of dividends reinvested you should probably decline the service!

Dollar Cost Averaging

When an investor has a lump sum, it can be daunting to invest the entire amount in the market immediately in one go. An alternative is to invest a fixed proportion of the lump sum regularly over a predetermined time period, e.g. invest £20,000 every month for six months until a £120,000 pot has been fully invested. This is known as dollar cost (or pound cost) averaging. Its purpose is to reduce the possibility of an investor making a large loss on their entire pot soon after investing – the investor is buying into a rising and falling market over a period, thus the overall price they pay to invest the lump sum is the average price over that period, not one high price before a market fall. There is no certainty on whether the investor will make a greater or lower return by using dollar cost averaging, but it does provide some downside protection.

Please note, when investing, your capital is at risk, and returns are uncertain. The information in these blog posts does not constitute financial advice and should not be considered as such.