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Back to Basics
Part II: How to Build Your Portfolio From the Ground Up
Editor's Note: The recent bear market has given investors an opportunity to revisit basic ideas for successful investing and why they can work in both up and down markets. This is the second article in a three-part "Back to Basics" series.
Build a Strong Foundation for Your Portfolio
Many people have built houses or watched them being built. But few investors outside professional circles have "constructed portfolios." Since this process is mostly mental and strategic, not tangible, it can seem more complex than it is. So, let's demystify how you should build your portfolio, once you've defined your investment goals.
"Portfolio construction" is financial jargon that means properly diversifying your money across asset classes and management styles, so that you obtain the lowest risk exposure for the potential return you seek to achieve. Think in terms of being a smart shopper in a store with a range of merchandise, from low to high quality.
Shopping wisely doesn't mean buying bargain-basement goods. It means insisting on value for your money. In portfolio construction, planning smart means obtaining the lowest risk available for a targeted return. It's difficult for many investors to understand that risk and return aren't always proportionate. You can easily expose yourself to more risk than you need, and more than can be justified by the return potential of your portfolio. A major goal of portfolio construction is to avoid overpaying in risk.
A house under construction rises from a concrete foundation. But where do you begin building a portfolio? Start by focusing on the concept of negative return, essentially, getting back less money than you put into an investment over one year in any of three major asset classes — stocks, bonds and cash.
We know that stocks are risky, but how risky? Applying negative return, the answer is that US stocks have produced negative return about 20% of the time, over extended periods of history. Bonds are less risky on the same basis, with less than 10% incidence of negative return. Cash is the least risky asset class because it almost never produces negative return. Next, accept a bit of wisdom that was proven in detail by the financial scientists who developed Modern Portfolio Theory: When you mix stocks, bonds and cash together, the blend has lower risk exposure than the sum of the parts. That's true because stocks and bonds don't usually experience negative returns at the same time, and cash can cushion downturns in either. Diversifying among these asset classes helps you avoid overpaying in risk.
The Frame: A Blend of Assets
Stocks, bonds and cash create a foundation for portfolio construction, so let's move on to the frame, which has two parts:
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- Select the portions in which you mix these three asset classes. The more cash and bonds you include, the lower your portfolio's potential for negative return. The more stocks you include, the higher the potential for negative return. The various mixtures available create a spectrum of risk levels, from very low to very high. Choose where you want your portfolio to be on this spectrum, perhaps with help from your financial advisor.
- Amid the stock allocation, diversify risk further by mixing among styles: large-cap, small-cap, growth and value. You also may diversify between US and international stocks and among money managers. This will help to minimize the price and performance gyrations of owning individual securities or a mutual fund that emphasizes one particular style or sector.
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At this point in the process, some investors falter over the concept of growth, as in this question: "Should I include some growth in my portfolio?" The answer is that you should always have some growth potential in your portfolio, because growth drives long-term return. Just don't "bet the farm" on specific growth stocks or a growth mutual fund. When you concentrate too much of your portfolio in growth, and especially in a few growth investments, you increase risk exposure.
The Roof: Your Time Horizon
That leads to putting the roof on the portfolio construction process — which is a long-term time horizon. When your portfolio has this shelter, you can be comfortable taking some short-term risk. Even if your blend produces negative returns, you can survive it with a reasonable expectation that markets will bounce back and your overall investment experience will be productive. Without a long-term horizon, some investors panic at the first sign of negative returns. They lock in losses near the bottom of the market, and don't participate in the gains of the next upswing. This compounds mistakes and drags down confidence. If you can't ride through negative returns, you are sacrificing the potential return on the upswing that justifies your risk. It may be the most common way of overpaying in risk.
Once the construction process is concluded, remember that a portfolio (like a house) requires maintenance. Your goals may change, and so may your time horizon, especially as you approach retirement. As investors move closer to the horizon of their goals, we at Russell believe they may want to select a period when investment performance has been strong and use that opportunity to begin reducing risk, by moving more assets into bonds or cash. This strategy increases the probability that you will meet your important financial goals with the financial resources available.
Few expert carpenters attempt to build a house alone, and perhaps you shouldn't try portfolio construction on your own, either. Don't be afraid to seek professional help.
Copyright © Russell Investments Canada Limited 2008. All rights reserved. See Important Legal Information. Date of first use: 05/23/01.
Past performance is not a guarantee of future performance.
This is a publication of Russell Investments Canada Limited. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
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