Investors often look at their investments in isolation. To avoid losing sight of the performance and characteristics of each instrument and to determine whether they really meet the investor’s objectives, it is necessary to have an investment plan and general overview of all investments.
Building a personal investment portfolio starting with a well structured plan will also give an investor the flexibility to manage the volatility of the market.
The investment plan can serve as one of the key elements of an investor’s wealth management plan, which may also include tax planning, estate planning, charitable giving and many more.
The typical steps include: Setting investment goals, establishing the appropriate balance of risk and return to achieve these goals, devising an investment strategy and allocating assets as well as a performance review and rebalancing of the portfolio.
Goals and limitations
When developing an investment strategy the first task is to determine the investment objectives. These objectives can be near, medium and long-term, such as the purchase of a home, financing a child’s education or retirement. Different investment strategies may be suitable to meet these individual goals and require a combination of capital preservation, moderate yield generation or capital growth targets. At the same time each strategy may face constraints and be limited by available cash resources, liquidity needs or an investor’s level of risk tolerance.
Managing the relationship of risk and return
As the correlation between risk and return usually requires that to generate higher returns an investor will have to take more risks, it is important to determine the minimum risk that is necessary to meet the objectives of the investment strategies. From a return perspective the investor needs to bear in mind that it is the “real” return less taxes and after inflation that is relevant here.
Although each investor will have individually different risk-return considerations when creating an investment portfolio, most of those will evolve around similar themes.
One of those key questions is how much risk an investor will need to take in order to achieve the investment objectives. Beginning with the required return from the investment a picture with regard to the minimum level of risk will emerge. For example, if the investor requires a real return of 6 per cent in order to fund the maintenance of a property, the required real return will help to quantify the risk that needs to be taken.
In order to make the investment plan more flexible the investor should also take into account how much risk can be tolerated. For instance if the investment return is lower than expected or the investment objective, such as the above mentioned maintenance of a property, requires a higher than anticipated return, how much more risk could be taken on to allow meeting the investment goals?
This can be calculated by running scenarios making varying assumptions about the probability of generating different levels of return. The result of this assessment of an investor’s risk capacity could in turn also mean that investment objectives will have to be revised to stay within tolerable risk limits.
The personal risk profile will also include the willingness of the investor to sustain short-term losses in order to meet long-term capital growth objectives. This personal risk appetite can change during the life on an investment. For example, the closer the investment plan gets to achieving the investment objectives, the more conservative the investment approach of the investor may become.
The financial crisis has also shown that investors are now reconsidering their personal risk tolerance, with some favouring less risky and more liquidity-focused strategies.
As the prediction and timing of future market movements is extremely difficult, most investors tend to be influenced by current market conditions and the current performance of their investments. This can lead to knee-jerk, near-term focused and sometimes counterproductive investment decisions. An alternative is the systematic allocation of assets with a view to achieving long-term objectives.
Asset classes group different investments with similar characteristics (eg cash, bonds, equities, commodities, currencies etc). Each asset class will perform differently given economic conditions. While the performance of some asset classes will be more correlated than that of others, it is possible to construct a portfolio of asset classes that are highly uncorrelated.
Although this will mean that the investor misses out on benefitting solely from the best performing asset class, the investor will also never be completely exposed to the worst performing asset class.
A balanced portfolio will thus find the middle of the market. By combining bonds and stocks for example it will be difficult for a portfolio to beat an equity fund over time, due to its fixed-income stake. However, it will typically beat the average bond fund in the long run, because of its stock allocation.
In other words asset allocation diversifies the investment. The purpose of this type of portfolio is therefore to reduce volatility and generate stable returns in the long-term.
The investment horizon, investment objective and ability to tolerate risk will help determine the desirable mix of stocks, bonds and cash.
The best investment strategy is the one that achieves the investor’s objectives with the correct balance of risk and return over the required investment horizon.
The allocation of investments to asset classes will often have a much stronger impact on investment performance than other factors such as the selection of individual securities or the timing of the investment.
While the allocation of assets to different classes represents a form of diversification in itself it is also necessary to diversify within each asset class, by investing in a number of securities within the asset class. This diversification is extended by selecting securities with different characteristics for example in terms of maturity and default risk.
There are two general approaches to asset allocation: the strategic and the tactical allocation of assets. Strategic asset allocation aims to achieve long-term objectives by setting base levels for each asset class without deviating from them. The portfolio will be rebalanced as market conditions change to maintain the pre-defined asset allocation levels.
Tactical asset allocation in contrast is less rigid and responds to changes in overall market conditions, ie the economic factors impacting each asset class such as interest rates, by raising or lowering the levels of asset classes accordingly. Tactical asset allocation aims to benefit from market timing by taking advantage of economic conditions that are more favourable for one asset class than another.
Another factor to consider when putting together an investment portfolio is the liquidity needs of the investor. Fixed-term investments like bonds with a fixed maturity date, close-ended mutual funds or fixed-tenure bank deposits require the careful planning of liquidity. The greater the liquidity of an investment, ie how quickly it can be converted partially or fully into cash, the more flexible the investment becomes. It is important in order to be able to rebalance the portfolio when the need arises or to satisfy investment objectives.
However, the flexibility of liquidity comes at the price of performance. In practice therefore a combination of liquid and illiquid instruments is often sought. The overall share of liquid instruments will then be dependent on the liquidity-performance trade-off.
Performance review and rebalancing
Not only will an investor’s financial objectives change over time, the performance of the various investments themselves will make it necessary that the portfolio will have to be rebalanced.
Investors should periodically review the performance of their portfolio against applicable benchmarks and make changes if required.
Over time each asset class will grow at different speeds from the others and thus change the make-up and allocation of the portfolio. This can also alter the risk profile of the portfolio.
In addition market conditions will change and require a change to the allocation of asset classes or the composition of each asset class.
The rebalancing therefore ensures that the original asset allocation is restored and may also enhance the performance of the portfolio.