LEVEL: BEGINNER
The first step in investing is research. Any portfolio manager will first research a market condition, the market’s past performance, and likelihood of future returns on particular asset types as well as how much profit companies will expect to see in the future. After the investor has a sense of how and why a market is going to change, he or she is ready to start investing.
Before jumping in and buying stocks, ETFs or any other security, any portfolio manager needs to first determine what level of risk they are willing to take on. Usually, investments can be considered anywhere from very risky to very low risk, but not all investors agree on the particular level of risk for each security. Your job as an investor is to make this decision for yourself.
Risk assessment is a separate issue that we will cover in a separate article. For now, we need to consider strategies for managing risk that will guide you through the process of deciding how much of your portfolio should go into which assets, and why.
Asset Allocation
The first component of your investment strategy is asset allocation. This generally involves determining investments across four main asset classes – cash, equities, fixed income, and a broad bucket called “other” for all other securities and investments such as alternatives, real estate, commodities, foreign exchange, ETFs, etc., each having unique risk versus reward characteristics which should behave differently over time. On the Zolio platform, ETFs are used to express views in all asset classes other than cash and equities.
Your total assets are the amount of money in your portfolio, and you don’t have to invest all of it. While most portfolios will invest the vast majority of the cash in a portfolio, you are free to invest as little or as much as you want in particular markets and keep the rest in cash. It is important to remember that keeping assets in cash is still investing–it’s investing in the U.S. dollar, if your portfolio is in dollars. If you think inflation is going to be high, the last thing you want to do is keep your assets in dollars. Instead, you may choose assets that will rise with inflation, such as gold or commodities. Stocks, too, usually rise with higher inflation.
Asset allocation strategy is an individual process. There is no predetermined formula that you can emulate to achieve your desired investment results, since asset allocation is determined by your trading plan. Asset allocation is very important because it can have a greater effect on the outcome of your portfolio versus the individual securities that you invest in. For example, if you put 100% of your money in stocks and the overall stock market falls because of a large scale event–this happened in the subprime mortgage crisis in late 2008 or during the downgrade of the United States credit rating in 2011– then your portfolio would go down, even if the individual companies you bought into were well performing, strong earners.
Diversification
Another way to manage risk in your portfolio is to diversify. Proponents of diversification state that, on average, investing in several assets will lower the overall risk profile of the portfolio and yield higher returns than any individual investment; thus making it a very efficient method of risk management.
This means investing in a variety of securities of the same type. So, instead of buying just one stock, you purchase many stocks. Or, rather than investing in only shares in Apple, you diversify in the technology sector and also buy shares of Microsoft, Google, and so on. Diversification is the fundamental of any sound portfolio, and no investor, no matter how savvy, can outperform the market for long without some kind of diversification.
Diversification seeks to contain security risk (risk associated with individual securities) and mitigate systemic risk (risks associated with being invested in the market). Under this theory, the positive performance of well performing investments will neutralize the negative performance of laggards in the portfolio thus balancing the portfolio’s returns.
Research has shown and supports the idea that a diversified portfolio of 30 stocks can effectively achieve a significant amount of risk reduction in a given portfolio (domestic stocks). Additional diversification can be achieved through investing in international securities since those markets are not closely correlated to domestic stocks.
Concentration
Asset allocation, including position sizing which is discussed separately, is the tool that portfolio managers use to decide how much risk they are willing to take on. Diversification is a strategy for lowering risk–but also lowering returns. Its antithesis is “concentration”, which raises risk and potentially raises reward as well.
Targeted, concentrated portfolios focus on achieving outsized returns for a set of given stocks. As a result, a concentrated portfolio is very risky. Under this strategy, an investor makes very targeted, specific investments in only a small number of securities (10-12) for the portfolio Optimally, the focus on a small number of stocks allows the investor to effectively vet and continuously monitor each investment in a close fashion, which should ideally lead to higher returns if the investments perform as planned. However, due to the small number of investments and concentration of assets, negative performers could greatly affect the overall performance of the entire portfolio.
Smaller, concentrated portfolios tend to go up and down more radically and faster than diversified portfolios. This is not inherently good or bad; several investors choose a concentrated portfolio in the hopes of achieving strong and fast appreciation thanks to a specialized knowledge or expertise in the field. A medical researcher who only invests in the pharmaceutical field would be an example of an asset manager concentrating to take advantage of a specific expertise.
Timing and Past Performance
Another important concept for managing the risk in a portfolio is determining its likelihood to go up or down due to past performance and the timing of the market. This is a controversial issue, as many investors believe no one can time the market, and past performance does not indicate the likelihood of similar results in the future.
To minimize risk, some investors will utilize technical analysis to determine the probability of a stock rising or falling. Other investors believe this information is of limited value or, in some cases, will actually increase the risk of a portfolio losing value. Needless to say, this is one of several controversies that remain in the world of portfolio management and investing, and many investors chose to use both technical analysis and fundamental analysis as a result.
Conclusions
Managing risk in a portfolio is an important factor when determining the success of a trading plan. Choosing the optimal strategy based on your risk tolerance, time horizon, and investment thesis is critical to the performance of your portfolio. There is no one right way to manage risk in your portfolio, and no one right level of risk that is best for everyone.
Many people think that all investors are looking to get as high of a return on their investments in as short of a time as possible, but that isn’t true. While everyone likes making money, all investors carefully consider how much risk they are willing to take when they invest, and this is usually the first consideration before deciding how much money they want to make. The more risk, the more reward, but lower risk portfolios are also a great way to make a steady profit from a more secure investment strategy. Your job, as portfolio manager, is to see where you feel most comfortable on the wide spectrum between risk and reward.