How to build a Robust Portfolio

After learning about the importance of Asset Allocation, let us consider the factors that are needed to build a Portfolio here. I had omitted the word "on average" in my earlier post and I also noted that the variation caused by Asset Allocation is 93.6% and not 95.6%. Hence I want to requote the result from the work of Brinson et al.

"Data from 91 large US pension plans over the 1974-83 period indicate that investment policy dominates investment strategy (market timing and security selection), explaining on average 93.6% of the variation in total plan return."

What does that tell you? It tells us that there is another important step ahead of security selection and that is to select the asset classes and their asset class weights. Then the logical order of decisions to be made are:

• Decision #1: What asset classes to invest in? Example: Stocks, Bonds, Cash, Gold, Real Estate, etc.
• Decision #2: What is the Normal weight of each asset class that is going to remain unchanged over time. Example: stocks 80%, bonds 20%.
• Decision #3: What securities to choose among each asset class and adjusting asset class values from normal values on a short term basis (Rebalancing)

Decisions (1) & (2) above collectively are called Investment Policy (or Passive Management) and the Decision (3) is the Investment Strategy (or Active Management). Did you notice that passive management terms are going to dictate the performance in the long haul than the ones from active management. Yes, thats what the result from Brenson's team said.

Now let us dissect each of these decisions to see how we can enrich our options to make a robust, well-rounded portfolio. The first decision is to choose the asset classes to invest in. Each Asset class has its inherent risks, rewards, forward-looking return rates, volatility and correlation with other asset classes. Depending on your situation you will have to choose the asset classes that can suit you. Following are some of the most commonly used asset classes and their attributes.

• Domestic Equities: volatile and can suit long term investment
• Foreign Equities: for diversification and balancing currency variations
• Emerging Markets: high returns and high volatility
• Fixed Income: stable cashflow and low correlation to other asset classes
• Fixed Income Enhanced: Bond Market, cashflow
• Real Assets: benefits during high inflation. Eg: Commodities, Real Estate, timberlands
• Private Equity: better returns, long term risk adjusted returns
• Structured Credit: below investment grade securities, extra cashflow via leverage

Many of these asset classes are not available for individual investors, but you can try to diverify your portfolio by selecting different asset classes as much as possible and still fit your investment criteria.

Let us navigate through this with an example. Bob is 30 years old and is planning a portfolio for his retirement at the age of 65 years. He thinks that since US domestic equities have been yielding ~8% annually and the political system in the US is stable that US markets should continue to do well, and hence Bob makes domestic equities as one of his primary asset class. Since he has long time to retirement Bob doesn't mind taking on some risk in order to generate some extra profit, so he chooses Emerging Market asset class also. Bob wants to protect his savings from inflation, hence he goes for Real Assets as well. And Bob adds Fixed Income asset class for some cashflow and for portfolio diversity.

The second decision to address is to assign weight for each asset category. Though Brenson et al observed that this proportionate weight among asset classes is going to remain unchanged over time. But this is more of a possibility for an institution like a Pension fund and not for an individual. Even with a pension fund, the portfolio managers can vary the weightage based on macroeconomic analysis. But for an individual focusing on retirement, this weightage should not remain constant. That is because the portfolio emphasis has to change from capital appreciation at the beginning of the career to capital preservation around the retirement.

In our example, Bob's retirement is not immediate and hence he plans to be aggressive with his investments. Below is weightage he comes up for his retirement portfolio:

• Domestic Equity: 40%
• Emerging Markets: 15%
• Real Assets: 30%
• Fixed Income: 15%

The third decision is to implement the Asset Allocation. This decision can take on two strategies: (1) Selecting the securities for each asset class and (2) Timing the market (or Re-balancing). For selecting the securities, if the asset class is domestic equity, then you can consider sub-asset classes like, Growth or Value, Large-cap or Small-cap, etc. Or you can directly invest in company stocks or equity options if you are comfortable dealing with them. Similarly you can choose short term bond or long term bond, Government bonds or Corporate bonds, if the asset class is fixed Income.

For Rebalancing the portfolio strategy, you can move into a sector that has better risk/reward ratio for the next few quarters. Say for example, if your macroeconomic analysis says that appreciating US Dollars is going to result in better returns from emerging market, then give enough exposure to emerging market sector to capture that growth.

Continuing with our example, Bob does his research to find the securities that fits the purpose and description of each asset class. Finally Bob's comes up with the following security selection for his portfolio:

• Domestic Equity: Large Cap, Large cap blend funds, and selected stocks like GE, AT&T, IBM, etc
• Emerging Markets: Small Cap growth and Emerging Market funds from BRIC countries (Brazil, Russia, India, China)
• Real Assets: Real Estate Investment Trusts
• Fixed Income: US Bond Market Index

If you notice, the portfolio that Bob has built incorporates principles behind Asset Allocation, Diversification, and Portfolio Management. If the same decisions are followed when rebalancing the portfolio, then your portfolio should be better manageable for performance, risk-control and for reaching your investing goals. The above description should give a fundamental idea about how professional portfolio managers manage capital for their clients.

- Nidhi