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How to construct a portfolio using simplified modern portfolio theory. Travis Morien Compass Financial Planners Pty Ltd firstname.lastname@example.org http://www.travismorien.com. Before viewing this presentation:.
Compass Financial Planners Pty Ltd
The presentation you are about to view on building portfolios is the “sequel” to a slideshow on selecting managed funds. Some concepts are carried forward from that presentation and are assumed knowledge.
If you haven’t already done so, download the original presentation from http://www.travismorien.com/investment.ppt
The asset classes
BWhy risk and return are linked..
Investment A is the obvious choice…
… but add risk, is the choice still obvious?
B would die out through lack of takers!
When two investments appear to offer identical risk, investors will prefer to buy the higher returning one. If the market is peopled by reasonably well informed investors, there simply won’t be any high returning low risk investments left and nobody will buy high risk assets with a low expected return.
The last twenty years have seen very good returns for all major asset classes, well in excess of inflation, but the risk and return are highly variable.
Creating diversified portfolios
There are two mechanisms by which diversification reduces risk: dilution and interference.
“Correlation” is the word given to the extent to which assets move together, this is measured with statistical formulae. Correlations can range from -1 (perfectly negatively correlated) through to +1 (perfectly positively correlated).
If asset B tends to move in the opposite direction to asset A then these two assets are said to have “negative correlation”, and they can be highly effective at cancelling out each other’s volatility. If the assets both trend upwards over the longer term a combination of them will have a return equal to the average of the two assets’ returns but with substantially reduced volatility.
Negatively correlated assets cancel the greatest amount of each other’s volatility.
Efficient portfolios on or near the efficient frontier
Inefficient portfolios below efficient frontier
The “efficient frontier” is the name given to the line that joins all portfolios that have achieved a maximum return for a given level of risk (portfolios that are “efficient”). If you programmed a computer to chart every possible portfolio that could be constructed out of a group of assets and plotted a point on a risk vs. return chart, the resulting plot usually looks much like the chart below. The top of the curve is the efficient frontier, anything below that curve is an “inefficient” portfolio, anything actually on the curve, or close to it, is an “efficient” portfolio.
Since 1982 Australian shares (ASX500 index), international shares (MSCI world index) and property securities (ASX300 listed property index) have had roughly the same return…
So using our simple rule of thumb that if the three assets have similar returns we’ll use a third in each, we get the following portfolio which has outperformed all three with much less volatility! (Rebalanced monthly)
A higher return may often be obtained from rebalancing the portfolio as a result of “reversion to the mean”.
If you believe that at some point in the future two assets will give the same cumulative return then it would make sense to invest in the asset class with the worst recent performance and sell the one with the best performance!
Rebalancing does precisely this, although it is normally seen only as a risk management technique.
This is why the diversified portfolio did a little better than all three component asset classes. A small “rebalancing premium” is quite common because last year’s worst performing asset class often outperforms last year’s best performing asset class this year.
Your returns mostly come down to asset allocation:
Picture credit: Dimensional Fund Advisors
Over the long term value stocks and small companies have outperformed large companies. These are the returns of global value, large company and small company indexes calculated by Dimensional Fund Advisors from January 1975 – December 2003:
Global value 19.70%pa
Global small caps 20.29%pa
Global large companies 14.98%pa
Adding value and small caps to a large cap growth equity portfolio gives a better return than a large cap only portfolio, but the volatility is actually lower, not higher. A mixed portfolio is more “efficient”.
20% Australian large
20% Australian value
10% Australian small
20% global large
20% global value
10% global small
Data from Dimensional Fund Advisors DFA Returnw program, gross return of indexes tracked by DFA equity trusts. See http://www.dimensional.com.au
*Annualised standard deviation is presented as an approximation by multiplying the monthly or quarterly standard deviation by the square root of the number of periods in a year. Please note that the standard deviation computed from annual data may differ materially from this estimate.
50% Australian large
50% global large
January 1988 to January 2004, DFA Emerging Markets index plus Global Large Company index.
A property of efficient frontiers is that the left side of the chart is usually a lot steeper than the right side. Addition of even a small amount of cash to a share portfolio (here we have used the ASX500 All Ordinaries share index from January 1980 to January 2004) can significantly reduce volatility with very little impact on returns and the addition of a small amount of shares to a cash portfolio can significantly increase returns without increasing volatility much.
Risk profiling and portfolio design
Over a short period of time there is very little difference so it may not be worth taking a risk, but if you do have a long term horizon then serious thought should be put into ways to get an extra percentage point or two out of the portfolio. An extra point of risk is often hard to notice without a computer, but an extra point of return makes a very big difference in the long term! Risk is important but being overly conservative can be a costly mistake over the long term.
Most advisors discuss risk tolerance in terms of potential volatility only, often using short multi-choice questionnaires. In my opinion, this is inadequate and doesn’t really address the client’s needs. I think there are actually three dimensions to risk profiling:
February 1985 to December 2003, monthly distribution of returns:Note the higher peak and narrow spread of the conservative portfolio compared to the higher risk portfolios, but note also that the riskier portfolios peak further to the right showing that on average they have had better returns.
Maximum drawdown is another way to look at risk which is more meaningful to most people. Drawdown is calculated as the loss from the highest previous high. The losses each portfolio experienced in past bear markets can be clearly seen and compared.
Compared to the individual asset classes, the historical drawdown of the diversified “High Growth” portfolio was much less. Individual growth assets have tended to have up to twice the downside risk.
Citigroup BMI value and growth indexes, July 1989 to Jan 2004 (Australian shares)Although the value index in this example outperformed the growth index by more than 3%pa, if there is much extra risk in value stocks then it doesn’t show in the volatility or drawdown figures.
Longer term in the US: Fama and French large value vs. large growth indexes January 1926 to December 2003. Again, if there is extra risk it isn’t obvious in the drawdown figures. Value outperformed growth by more than 2%pa over the entire period but this didn’t translate into meaningfully greater downside risk. Value was marginally more volatile though, 7.45% per month vs. 5.48%.
In the late 1990s, growth stocks outperformed value stocks. If you had switched out of value and into growth following that period of outperformance you would have been hurt badly by the bear market that followed, where value stocks outperformed growth by a big margin.
Growth stocks often outperform in rising markets, especially in the latest stages of bull markets when most people invest the most money. Typically, value stocks offer more consistent performance.
If you can’t tolerate underperforming the market or don’t want to bet on a value premium continuing, stick with normal large cap “blue chip” shares. Strongly tilted value and small cap portfolios aren’t suitable for everyone.
Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Investors should seek the advice of their own qualified advisor before investing in any securities.
Please note that returns quoted in this article are based on historical performance of indexes, not actual products. Real world products (index funds) are available to track the majority of indexes quoted in this presentation, but returns will be affected by fees and taxes. Past returns are not a reliable indicator of future returns.