Portfolio Management: It's for Dinner

Posted By: Advisor Analyzer Team

Anyone that has ever made a homemade meal knows they should first determine how much to make, what dish to prepare and obtaining the ingredients needed for the meal is one of the last steps. Few would argue that capriciously mixing their favorite flavors and arbitrary ingredients would yield the same result as following a recipe line by line. Much like creating your favorite culinary dish, investing one’s portfolio should be a well planned and thought out process. Unfortunately, not everyone uses a recipe in portfolio creation and many whimsically play it by ear when it comes to investing.

 

There are two types of investors in the market today. One group focuses on their investment portfolio from a stock by stock basis. They often fail to strategically plan portfolio allocations, and consequently lack method and discipline in their investing behavior. They purchase stocks when they believe it will outperform and sell if they feel otherwise. In the culinary sense, their actions are comparable to chopping up vegetables, and boiling water, without first deciding what they will have for dinner.

 

The second group takes a more strategic route to portfolio creation. They determine the overall asset allocation for the portfolio prior to deciding which investment to purchase.   Only after determining the overall portfolio allocation do they begin the process of stock selection.  Their actions are akin to looking through a recipe book to first determine what they would like to have for dinner, then going to the grocery store and buying the needed ingredients.

 

Which approach is better? Although some may enjoy experiencing new dishes and improvisation, in the world of finance the latter approach has often proved a more fruitful endeavor. The goal of this article is to simplify portfolio creation and show how strategically planning the allocation in advance can prove better in the long run.

Determine Asset Allocation

Before an investor decides to analyze a company’s financials or the stock’s recent activity in a one year chart, they should determine a suitable asset allocation that aptly meets their investment objectives. (Obviously an investor must first establish investment objectives, and constraints but that’s for another article.) An investor should take a top down approach to portfolio creation, by determining how much should be allocated to equities and fixed income.  

 

The general rule of thumb when determining how much to allocate is:

 

· 100 – an investor’s age = % Equity allocation  

 

For example, a 60 year old investor should invest 60% of their assets in fixed income securities, and (100 - 60) = 40% into equities. Using our cooking example, determining the asset allocation is similar to calculating how many people you will be cooking for; will you eat alone or for the whole family? Determining the proportions is an essential initial step in cooking, and is no different in the world of portfolio creation.

Determine Industry Exposure

Once an investor has determined how much equity exposure is suitable, they should determine how the equities should be invested. Before determining which individual investment should be purchased, an investor should decide how much of which industry will yield superior performance. For example, an investor must determine which industry and sectors are most attractive; commodities, large cap stocks, the financial industry etc. and the amount of funds that should be allocated to each sector.

 

To determine asset allocations, it’s often wise to analyze the historical performance of each sector. While far from a crystal ball, historical data can aid in assessing the past volatility and trading characteristics of each sector.

Those more mathematically inclined may take it one step further by manipulating data to predict potential future movements. However, it’s often the case that individual investors lack the financial sophistication or the forecasting savvy to manipulate historical returns data using scenario analysis or Monte Carlo simulations. Those less familiar with such statistical processes can still obtain rough estimates of historical industry performance looking at a 1-3-5 year charts or other historical pricing data.  

 

Using historical figures, the investor can better determine how much funds should or should not be allocated to an industry or sector. Once the investor has determined the desired exposures they are able to estimate the expected return and risk (measured by standard deviation) of the overall investment portfolio.  

 

Returning to our dinner example, this step is similar to determining what main course, side dishes and desert to prepare that evening. Much like deciding between a rib eye steak, potatoes and an apple pie for desert versus chicken and rice with a chocolate cake, determining the which sectors to invest in are important choices when investing one’s portfolio.

Deciding the Investments

Next the step in portfolio creation most investors are familiar with: investment selection. After determining the right amount of exposure to each specific sector, an investor must assess which investment is most attractive. For example, an investor may want exposure to the automotive index. However, within this industry are many different companies such as Toyota, General Motors or Ford to name a few. Each company has its own performance history and unique operating structure. Put bluntly, not all of these companies will perform equally. Therefore, it is up to the investor to sift through these companies to determine which will best outperform the index.

However, suppose an investor is not confident in their stock picking abilities, but would still like exposure to the automotive industry. Fortunately, the investor has at his disposal, the option to purchase an exchange traded fund (ETF). Exchange traded funds endeavor to mirror the performance of an index or sector. Therefore, the investor is able to obtain the desired exposure without the need to select outperforming stocks.

 

If we were to compare this to our food example, it is very similar to deciding between different packets of chicken, squeezing fruit and finding the ripest vegetables. As for ETF’s, imagine a novice cook who is uncertain of their abilities to prepare stuffing from scratch; they have available premade stuffing such as Stovetop, or Perdue that is very similar in flavor.

Conclusion

Much like determining what you would like for dinner, portfolio creation works best when there is a well thought out strategy that is implemented. It should be a step by step process that takes the multitude of investments available and filters the most suitable security for one’s portfolio. While for the more adventurous, randomly mixing different ingredients may be an exciting process with the potential to produce a uniquely enjoyable dish, following a recipe for the rest of us is often the more advisable decision.