Construction Methodology for Optimal Portfolios - Part Two
Last week we discussed the premise that diversification is of paramount importance for investors who wish to prudently manage risk. By now, the principle of diversification is almost universally understood (though not necessarily put into practice) by the everyday investor. We then examined the extent to which asset class selection influences outcomes of portfolio returns as compared to specific security selection and market timing. The evidence shows that those who accept that markets are efficient and that all the available information is efficiently reflected in the price of a security do considerably better over the long-term. Similarly, those that postulate that they have an edge on the market collective and believe that they can add value by choosing winning stocks and timing markets do comparatively worse over the long-term. Academic research into this field has found that you can accept the hypothesis that markets are efficient and still capture additional premiums by exposing your portfolio to certain factors. We will examine the methodology of tilting your exposure to these factors and the benefit to investors in next week’s article. In the meantime, a further exploration is needed on what money managers mean when they use the word “risk.”
Risk is one of investors most misunderstood words. Hearing it can produce sentiments of fear, often paralyzing individuals from taking action. The cruel irony is that inaction also comes with inherent risk as well! Put simply, risk is the likelihood of not achieving your objective. In investments, risk can be quantified by looking at the volatility of a portfolio and measuring its standard deviation. The more a portfolio deviates from its average, the more intrinsic risk there is within the portfolio.
Volatility (risk) is the cost of admission to the game of investment. By now we have reviewed that the return you get is the reward for bearing risk. Accepting this premise, prudent investors will do well to ask the question - “Am I being compensated fairly with a reasonable return for the degree of risk that I bear?” This is a question that investors overwhelmingly neglect to ask themselves. Often investors are paying first class prices (high volatility) for sub-optimal outcomes (lower expected returns).
The relationship between the risk and expected return of a portfolio can be used to describe its efficiency. In an efficient portfolio, diversifiable risk is eliminated providing the investor with the highest return for the amount of risk assumed. This maximum portfolio efficiency is known by investment professionals as the ‘efficient frontier’.
Efficient Frontier
The important issues to understand from this diagram are:
Portfolios A, B and C fall on the ‘Efficient Frontier’,
Portfolio D is an inefficient portfolio as it has the same degree of risk as Portfolio C, but has a lower expected return than Portfolio C, and
Whilst the increase in expected return from Portfolio A to B is the same as that from Portfolio B to C, the increase in risk is significantly greater.
Overall, this exercise demonstrates that investment return and investment risk need to be identified at all times. The danger is that the investor with Portfolio D, who has achieved the same return as Portfolio A may be satisfied that this is a relatively good outcome. However, the fact that Portfolio C delivers a higher return than Portfolio D for the same level of risk demonstrates that Portfolio D is not optimal.
Portfolio D reflects a portfolio that has high exposure to ‘unrewarded risk’, which typically includes high levels of stock specific risk, as well as high trading costs from fund managers constantly buying and selling in an attempt to time the markets. Portfolio D is essentially a classic example of the trap many investors fall into. The constant and sole focus on returns in many instances blinds the investor to the fact that there are better and more efficient ways of investing than active stock selection.
To this point, we have focused on equity investments, however, how does fixed interest fit into a properly constructed portfolio? Ultimately, where fixed interest is included in a portfolio, it is used primarily to reduce volatility within a diversified portfolio.
Importantly, where fixed interest is included within a portfolio the performance of this asset class should not be considered in isolation, but the impact it has on the portfolio’s overall performance. Ultimately, there will be occasions where fixed interest may produce negative performance particularly during a period of rising interest rates - 2022 was a stark reminder of this fact. However, it is the complimentary nature of fixed interest within a portfolio that is important.
Fixed interest has traditionally been thought of as a “safe haven investment” during times of uncertainty. In times of economic or political volatility including periods of cross border hostilities, the higher certainty that comes with quality Government bonds increases in attractiveness as a safe haven asset. For this reason, fixed interest ranked as the best performing asset class in periods of high uncertainty when equity tends to perform badly. The lower correlation in price movements between fixed interest and equity investments makes bonds and cash a prime addition to portfolios as a volatility dampener to limit the range of losses.
The other issues that needs to be considered is whether returns available within the fixed interest market can be generated more efficiently given the underlying risk involved. However, research has shown that the risk premium available within the fixed interest market is quite small and yet the additional risk (volatility) that needs to be accepted in attempting to capture that return is quite high[1]. This research confirms the premise that fixed interest should be used a volatility dampener.
When using fixed interest within a portfolio, two additional factors are considered;
► The term; and
► The credit quality.
In order to ensure the volatility of the fixed interest component is kept relatively low and maintain the complimentary nature of fixed interest to equity, only high credit quality options should be considered as well as those with shorter maturity periods of five years or less.
So far we have discussed some of the theoretical underpinnings supporting the importance of the asset allocation decision, however what is the process followed to build portfolios using the asset class methodology? This is what will be discussed in next week's article.
[1] Fama Jnr, Eugene, ‘Common Risk Factors in Hybrid Investments’ Dimension Fund Advisors, May 1995
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