Choosing what to (and what not to) invest in may seem like a simple task. For some it involves couch potato investing in a single asset allocation ETF (like VGRO, XEQT or ZBAL) and to others it involves buying a few hot ticket items with the hope you get a 10-bagger.
What you may overlook is how to properly structure and manage your portfolio strategy, especially when you start investing. The key ingredients to this are:
- Asset allocation
- Geographic exposure
- Correlation of assets
- Risk & Return attributes
Asset allocation is the process of segmenting your portfolio between different asset classes - mainly equity and bonds.
This segmentation is usually a result of your risk tolerance. A more conservative investor would historically place a higher weighting in fixed income and a more aggressive investor would place more weight in their equity sleeve.
Pension funds and more sophisticated investors will also include an alternatives component (15%) dedicated to assets like infrastructure or hedge funds.
To mitigate your risk, it's important to consider a globally diversified portfolio. The thinking goes, if the US starts selling off, at least my other holdings are okay. In actuality, often a problem in one market can bleed into others, with many global markets taking direction from how the US is behaving.
The most important thing a Canadian investor should consider is, am I too overweight Canada? There tends to be an over concentration in domestic equities, where one should consider diversifying away into the US - and more selectively into international markets. Historically the US has shown the most consistent positive returns out of any market, with increased volatility outside North American markets.
Correlation of Assets
When building a portfolio, you need to consider how your holdings interact with one another. A common example is the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google). While they all are in different businesses, they are all mega-cap tech companies that get picked up in popular indices and thus follow similar trends.
Look at the one to five year price history of your desired portfolio and run a correlation matrix to see how these securities have performed. If you find yourself with correlations routinely over 0.6, time to reconsider your holdings.
Risk & Return Attributes
Consider these following risk indicators for your portfolio: volatility, Sharpe ratio and beta.
Portfolio volatility is how much your portfolio will move around in a given timeframe - often 1-year standard deviation. High volatility indicates that your portfolio could rise and/or fall by that much in a given year.
Sharpe ratio looks at the risk-adjusted return of your portfolio. You should aim for a high Sharpe ratio (over 1) as you are being rewarded for increased risk.
Beta is a measure of correlation with the wider market. A beta over 1 means your portfolio moves in excess of what the market does. A beta between 0-1 means your portfolio will not move to the same magnitude as the market and a beta less than 0 means your portfolio will move inverse to the market.
Return attributes include total return, price return, dividends, contribution to return.
Total return is simply the price return + dividends paid out. A higher number the better. It's important to consider the make-up of this return though depending on your goals. A high price return maximizes capital gains versus a high dividend return which maximizes distributions, and a higher tax bill.
Contribution to return is the individual contribution a security, sector or factor had to your portfolio. If you had 1 winner and the rest of your portfolio returned negative, you may want to consider how that portfolio is constructed.
Summing It All Up
While this can certainly feel like a daunting exercise, a properly constructed portfolio doesn't need constant monitoring. After you've made your desired portfolio, look to measure its ongoing performance and rebalance on a monthly to quarterly basis.
We understand the complexities of building portfolios, hence why we created Investipal. If you want a pain-free way to build the right portfolio for you, check us out.