The investment universe offers a lot of possibilities. The goal is to construct a portfolio which meets the investors requirements for both risk and reward.
Asset returns vary among the different asset classes shown previously (see blog post: Investment Options). Additionally, the assets typically cycle from being undervalued where they have a higher future expected return and overvalued where they have a lower future expected return.
Volatility and maximum drawdown are measures of risk. Volatility refers to how much variability there is in the value of an asset. Maximum drawdown is the maximum amount the value of an asset has fallen from a peak. During the financial crisis in 2009, the S&P 500 bottomed with a 51% drop from its previous high. Some individual stocks lost 90% of their value or even went bankrupt. Individual stocks have some of the highest volatility and highest potential return while cash and cash equivalents have the lowest volatility and lowest return.
Investing in pooled assets such as mutual funds, Exchange Traded Funds (ETFs) and Real Estate Investment Trusts (REITS) can help to lower volatility by diversification across multiple holdings. Additionally, investing in uncorrelated assets lowers volatility (see blog post: The Importance Of Correlation).
When constructing an investment portfolio, the investor's objective, risk tolerance and time horizon control the asset selection and weighting.
Investment goals are unique to the investor. For example, some investors may prefer current income over growth or capital preservation. We define three investment goals for a portfolio: capital preservation, current income and growth.
The risk tolerance of the investor has a major impact on portfolio construction. People tend to feel losses greater than they feel equivalent gains. This is known as loss aversion. Imagine the pain felt with a 51% drawdown similar to that in 2009. U.S. stocks have periodically (1974, 1987, 2002, 2009) lose between 30% and 50% of their value. If these types of losses are unacceptable, a portfolio of 100% stocks is not desirable. We define three risk tolerances for a portfolio: conservative, moderate and aggressive.
The time horizon is important as well. If portfolio losses can be tolerated in the short term, but the portfolio value needs to be realized at a defined point in the future, it will affect portfolio construction. For example, the S&P 500's 2000 peak was not surpassed until 2006 when adding in dividends. Investing in stocks in 2000 with a short term time horizon would have been unwise. We define three investor time horizons: short (0-5 years), medium (5-10 years) and long (>10 years).
Finally, once the goals, risk tolerance and time horizon are defined, combined with a basic understanding of probability and statistics the portfolio can be constructed from the various assets classes with appropriate weightings to meet the investment objectives.
The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.
The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.
Performance data showing past performance results is no guarantee of future returns.