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Constructing a winning portfolio

23 May 2011

Portfolio construction is about understanding how individual stocks behave when mixed with other stocks. It’s also about understanding your own objectives and your risk profile.

So how do you go about constructing the ultimate stock portfolio that’s just right for you?

Why diversify?

When you consider how well stocks ‘play together’, and it be pretty amazing because sometimes by adding in a higher risk stock, you can actually reduce the overall risk profile of your total portfolio.

When you look at diversifying stocks, it’s all about choosing assets which have a low correlation. In other words, this means choosing assets or stocks that do not move together. Choosing assets that move in different ways helps you minimise risk.

So if diversification is all about risk minimisation and not necessarily maximising returns, you may think that you shouldn’t bother diversifying at all. Indeed, Warren Buffett says:

 “Diversification is only required when investors do not understand what they are doing”.

In a way he is correct. If you are trying to achieve the best return then the best strategy would be to pick the one best performing stock and put all your money in that basket. However, the problem with this strategy is that that most people don’t have a crystal ball. What if that stock tanks?

That’s why risk management is just as important as trying to maximise your returns. Forecasting returns can be more about understanding probability than about accuracy.

Basic theory

Traditional portfolio construction is all about understanding the relationship between risk and return.

To understand risk and return, you should consider your own financial situation and needs. You might want to think about questions like:

1. Are you risk averse (ie conservative) or risk tolerant (ie high risk) ?
2. Are you approaching retirement?
3. Are you looking at growing your assets over a longer term?
4. How much time do you need before your assets need to be turned into cash?

Below is a general scale showing low risk portfolios through to high risk portfolios and their possible asset allocation:

• Low risk or conservative portfolios generally have most assets in cash and fixed interest.
• Medium risk or balanced portfolios generally hold a range of assets such as cash, fixed interest, property and shares.
• High risk portfolios generally have more than 90% of assets in growth assets such as Australian shares, emerging market shares, international shares, and domestic or international property.

Where do you think you sit in that scale?

Measuring success

Most portfolio managers will compare their return against general market returns to measure success. If the market lost 15%, portfolio managers would be happy with a negative 10% return. But I would think that you would not be so happy with a negative 10% return! Most investors would be striving for a positive return and strong performance.

Choosing companies that will outperform

So when you construct your portfolio, how do you choose companies that will outperform the market?

There have been a number of academic studies into outperformance which give some interesting insights:

• Many studies have shown that low P/E stocks have historically outperformed the market compared with high P/E stocks.
• Technical analysis studies have also shown that using indicators like a 50 day, 100 day, 150 day and 200 day moving average historically results in outperformance against the market.
• Lastly, contrary to popular belief, small companies tend to outperform the big ones. The ‘small firm effect’ describes the historical tendency for small capitalisation stocks to outperform the large capitalisation stocks.

To construct or rebalance your portfolio, think about risk versus return and how you can choose good quality companies to invest in. That way you’ll be rewarded with a diversified portfolio that outperforms the market.

Happy trading!

Julia Lee
Equities Analyst
Bell Direct