During times of market turbulence leading to poor performance across the board, investors often abandon their original investment focus and chase shadows. In such periods, it becomes essential to return to the fundamentals of portfolio management. This is crucial in helping both private and institutional investors stay focused. Private wealth advisors and investment consultants have a significant responsibility to guide their clients through these challenging times.
As advisors, we can help client evaluate whether their investment still has good future prospects and whether it is still suitable for the client’s circumstances. We have an important role to play in helping clients achieve effective diversification, among others, and avoiding a concentration of risks in particular investments, no matter how familiar they are. We should caution clients that familiarity is not a substitute for a good spread of investments. However, there are tested investing strategies open to investors, both individual investors and institutional investors, which can be adopted for optimal market returns. Here we go.
Efficient Portfolio Diversification
Your expected returns will largely depend on the level of risk you are willing to take. This risk-return trade-offs simply tells you ‘no free lunch’. Meaning you should be prepared to accept higher risk if you hope for higher returns, but with diversification as a strategy, investors can achieve more. Harry Markowitz work on modern portfolio theory at Yale’s Cowles Foundation, has said that diversification is a free lunch, meaning, if you diversify your portfolio for a given level of return, you can generate that return at lower risk. If you diversify for a given level of risk, you can generate higher returns. To consistently outperform the market, diversification is a proven strategy opens to institutional investors and HNWIs
But how should you diversify and what securities characteristics should make up your portfolio component? Traditionally, diversification tells you to spread your risk across different marketable securities (such as stocks, bonds, money market securities) which to some extent it’s quite rewarding, but the point is you are not well diversified. Because stocks and bonds, for instance, under many circumstances will respond to the same driver of returns, i.e. interest rates, in the same way. Lower interest rates, mathematically, are good for bonds, since lower interest rates lower the discount rate to discount future earning streams, so they’re probably going to be good for stocks too and vice versa.
Your portfolio is deemed well diversify if you got your assets classes in both marketable securities and some less liquid assets such as real estate, private equity, etc. This provides opportunity for excess market returns of which Sharpe ratio, a measure of risk in term of standard deviation of returns, do not capture. The reason is because the risks that exist in the portfolio aren’t really captured by the standard deviation of the returns. So, if you’ve got a portfolio that’s largely marketable securities, you’re going to see a lot more standard deviation of returns than if you’ve got one of illiquid assets.
Asset Allocation as a Strategy
The next decision to make is in which proportions you’ll hold those assets? This is called asset allocations. The simple step to arrive at asset allocation decision is to ask the following questions after your risk tolerance level is determined; how much in domestic stocks and bonds, how much in foreign stocks and bonds, how much in real estate. If you’re an institutional investor or HNWI, how much in private equity, commodities, leveraged buyouts, and venture capital should bother you. This is the fundamental decision of how portfolio assets are allocated. Roger Ibbotson at Yale School of Management did a fair amount of work looking at the various sources of returns for investors a number of years ago; he came out with a finding that more than 90% of the variability of returns in institutional portfolios had to do with the asset allocation decision. So then, asset allocation is far and away the most important tool available to any investors
Security Selection
The other decision tool as strategy is security selection, the choice of selecting specific securities within an asset class. Where you have established the asset allocation strategy based on risk considerations, there’s the need then to fill each asset category with specific individual securities and/or mutual funds to satisfy the allocation. When this is done, you come up with approaches to selecting individual securities. If for instance you are keen to selecting stocks, then your approach should focus on (a) the company fundamentals. That’s using firm-specific financial and accounting data to determine if the enterprise is strong. You employ financial statement analysis and accounting ratio analyses of the firm to arrive at a decision. (b) Price History. That’s by investigating how the stock has performed recently and using basic technical analysis (c) Price Target. That’s by working with selected valuation techniques and comparing to similar firms to estimate a stock price target over the next 1–2 years (d) Catalysts. This is by establishing an opinion of a stock based on publicly available information and news and lastly (e)Comparison: comparing a stock with two other stocks in the same industry sector.
Selecting mutual funds is another good selection strategy. One way to think about this is to buy the market, and the way that you can buy the market is to buy an index fund that holds all of the securities in the market in the proportions that they exist in the market. If you buy the market, then your returns to security selection are zero, because your portfolio is going to perform in line with the market.
Market Timing
The other strategy available to investors among others is to make a market timing decision. Market timing decision tells you to buying low and selling high. It also encourages investor to take a bet on the market. How? Here it is, if you establish targets for your portfolio, targets with respect to how much in domestic stocks, how much in domestic bonds, how much in foreign stocks for instance. And then, because in the short run, you think that (let’s say domestic stocks are expensive and foreign stocks are cheap) you decide to hold more foreign stocks and less in domestic stocks, what you’ve just done is called a bet. That bet, that is short-term bet against your long-term targets, is a market timing decision. And the returns that are attributable to that deviation from your long-term targets are the returns that would be attributable to market timing.
Research has shown that most investors used market timing to damage portfolio returns. That is making bad preference to chasing performance by buying something after it’s gone up, selling something after it’s gone down due to panic and negative news. Morningstar Company did a study of all of the mutual funds, 17 categories of funds, in the U.S. domestic equity market some years back. They looked at 10 years of returns and compared dollar-weighted returns to time-weighted returns. The time-weighted returns are simply the returns that are generated year in and year out, while dollar-weighted returns take into account cash flow. The outcome of the study shows that in every one of those fund categories, the dollar-weighted returns were less than the time-weighted returns. What does that tells us? It simply tells us that investors systematically made perverse decisions, as to when to invest and when to disinvest from mutual funds. That is investors were buying in after a fund had showed strong relative performance and selling after a fund had shown poor relative performance. So, they were systematically buying high and selling low, what a bad way to make money!
The Key Take Away
Achieving a considerable and efficient portfolio management, it necessary that investors think of what it’s good for them rather than joining what we call herding in investor behavioural biases. Going forward, institutional investors and affluent clients should consider carefully the outcomes of past investment decisions, making an honest assessment of what went well and what did not, because lessons can be learned for future decisions