Constructing a Portfolio

When constructing an investment portfolio, there are typically four main steps to take:

1.

Decide which asset classes to include in the portfolio.

2.

Determine the proportion (or weight) each asset class will have in the portfolio (e.g., will the stock asset class be 20%, 50%, 80%, or some other percentage of the total portfolio?).

3.

Select individual securities or funds within each asset class to either represent that entire asset class (in the case of funds) or attempt to achieve superior returns within that asset class (in the case of individual securities).

4.

Make adjustments at certain points in time to exploit short-term fluctuations and slightly increase returns. This can range from simple regular rebalancing to full-blown tactical or dynamic asset allocation.

Traditional asset allocation, also known as strategic asset allocation, focuses on steps 1 and 2. It is designed to help maximize the risk-adjusted returns of an investment portfolio by reducing volatility (as defined by statistical variance). The assumption is that volatility is the source of risk in a portfolio. That assumption is a convenience, not a law — it makes the mathematics tractable, and it quietly fails in exactly the conditions that matter most. section “MPT Under Deep Uncertainty” returns to where it breaks.

For example, if you determine that you need to earn a 7% annual return on your investments to achieve your goal of retiring in 25 years, then under a traditional asset allocation approach, you could (based on average historical returns):

• Choose to place all the money into stocks, accepting periods where your portfolio might drop 25–50% or more in value.
• Put all the money into bonds, though the average rates of return might be too low to reach your goals.
• Allocate your money into a mix of asset classes that allows you to achieve your 7% goal. This might involve having a higher percentage in stocks and REITs, and a lower percentage in bonds, with the understanding that some asset classes move inversely or are uncorrelated (for example, in 2020 government bonds increased in value as stocks declined due to global health and economic concerns). This diversification reduces overall portfolio volatility and protects your capital.

A proper asset allocation is supposed to help you achieve the returns you need with the least amount of risk.