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Constructing a watertight portfolio

How do you build your investment portfolio? I’m not asking about the mechanics of the process, or the advisor you work with. What’s your philosophy? What sort of activities will give your portfolio higher returns over the long run?

There’s no single, right answer to this question. Our individual needs, goals and experience mean that personal characteristics such as risk appetites and investing time frame must come into consideration.  Nonetheless, there are a number of key choices that all investors face.

Asset allocation

Many studies and academic papers over the years wrestled with an important investment question. Which decisions most affect portfolio returns? Although there is still room to argue, many come to the conclusion that asset allocation is the most influential. That is, it’s not the individual share, deposit or property chosen, but how the portfolio is split among these asset classes. The first decision investors should make is how they will divide their investments among shares, property, bonds, cash and other asset classes such as commodities and collectibles.

A generally accepted principle is the longer the investor time frame, the more risk. Truly long term investors have the ability to wait out market storms and potentially capture higher returns.

In asset allocation this means a greater weighting towards shares. Investors with shorter time frames and lower risk appetites are likely to favour more capital stable investments like cash and bonds.

Portfolio selection

Once investors have guidelines for asset classes it’s time to think about individual investments in each asset class. Although I invest in both, I’ll leave the property and bond markets to those engaged full-time.

Cash is the ultimate capital stable investment but it carries a significant and often ignored risk. Underperformance. Receiving 1-3% returns when others are earning 5-20% is devastating to wealth over the longer term.

This brings us to share portfolios. Naturally, most investors look to buy high quality stocks cheaply, while taking advantage of the risk reducing power of diversification. Seems straight forward. BUT. We don’t all agree on what constitutes high quality, and the only way to be sure of buying at low points is with hindsight.

In broad terms an important differentiator is whether investors build their portfolios from the bottom up, or the top down. Building from the bottom up usually means identifying stocks that are cheap or undervalued, and buying them with a view to long-term appreciation. Conversely, top down investors decide the type and style of portfolio they believe best suited to conditions, then seek individual stocks that meet the criteria.

Neither style is right or wrong. Investors with distinct investment profile will probably maintain a style over the longer term. Other more adaptable investors will adjust their style to the conditions. Both approaches involve risk. Investors who never change may be caught in extended periods of underperformance, where their investment preferences remain out of fashion. Investors who change too regularly face increased cost and exposure to whip-sawing.

Identifying the appropriate stocks is made easier by the proliferation of tools available to individual investors. Almost all top tier online brokers offer their clients software that will scan the market for stocks that fit investors’ criteria.

Fundamental scanners can be set to find stocks with multiple parameters. A bottom up investor may search for stocks with a market capitalisation above $100 million, a dividend yield higher than 5% and a P/E ratio below 12. A top down investor may seek a stock in a particular sector that has upwardly revised earnings and positive price momentum. Whatever the investment style, a fundamental scanner can vastly reduce the search time.

Similarly, some investors use a technical analysis scanner to identify opportunities. One investment use of a chart scanner is to scan for more reliable patterns on longer term chart. A search for double bottoms and reverse head and shoulders formations on weekly charts can identify stocks breaking upward from lower trading ranges, potentially alerting investors at the early stages of a rally.

Investors face many choices. One involves technology. An investor can rail against the rise of algorithmic trading, or chooses to embrace the new world. In the age of a technological arms race, staying up to date with the latest tool scan be as important as staying up to date on the market. 

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