Building the Perfect Portfolio

Those of you that have been following this column on a regular basis, may be familiar with the phrase “high risk, high return” when it comes to investing. But wouldn't it be nice to live in a world of maximum return with minimal risk? Can this be possible you may wonder? Harry Markowitz won a Nobel Prize for answering that question. Those of you that have not heard the name Harry Markowitz before, don't worry, nor have I for that matter, until I went to a Graduate School some years back.

What Markowitz proved was that a portfolio with two assets that don't move in tandem will have lower risk than either asset individually. Taking that idea further, he asserted that you could create a portfolio maximizing expected return for any given level of risk. In 1990, Markowitz shared the Nobel Prize in Economics with William Sharpe and Merton Miller for his ground breaking work on asset allocation and over the years it has inspired many offshoots, such as Efficient Frontier, Optimizers and Value at Risk. Don't let these fancy names scare you. They all boil down to one thing: Don't put all your eggs in one basket.

But which eggs go in which baskets you may wonder? To figure that out, you need to answer a few basic questions on our Risk Quiz to help gauge your risk tolerance.

The M&W Risk Quiz

1. What's the most important goal of your investment portfolio?
		To preserve capital To generate regular income while the portfolio grows over time. To grow substantially over time.
2. Investment X will grow, on average, at 5% a year with no risk. Investment Y will grow at 10% a year, but could lose 20% or more in a given year. Which one is more attractive to you?
		Investment X A mix of X and Y Investment Y
3. When do you think you will need to start using your money?
		Within 5 years Between 5 and 10 years More than 10 years
4.Which prospects is more appealing to you?
		Investment X: average annual return of 3%; best year, up 8%; worst year, down 4% Investment Y: average annual return of 12%; best year up 40%; worst year, down 20% Investment Z: average annual return of 17%; best year up 120%; worst year, down 55%
5. You just inherited a house in need of some repairs. The housing market is robust now, but there's no telling what it will be in a year from now. Do you:
		Sell it now Rent it out Make repairs and sell it in a few years

Total scores:
Note: 1 point for each A answer, 2 points for B and 3 points for C.

Score 5-8: Conservative.

Losing money really bothers you. You should have a fair amount of bonds and cash.

Score 9-12: Moderate.

You are willing to take some risk to make a decent return. At least half of your money should be in stocks.

Score 13-15: Aggressive.

Big losses don't bother you if they lead to big returns. Tilt your portfolio predominantly toward stocks.

It is worth noting that risk is more than just the chance that an asset will fall in value. Rather, it's a measure of its volatility, both up and down. This measure is called standard deviation, and it's calculated using the historical range of possible outcomes for a given security. The higher the standard deviation the riskier the investment.

 

If losing a lot of money makes you uneasy, you are probably to the left of 8%. That means you want a portfolio that stays within 8% of your expected annual return two-thirds of the time. If you can handle some risk, you are in the 8 to 15% range. And if you are a gambler at heart, you are out on the far end.

Markowitz's breakthrough, whose firm, Financial Engines, created the above chart- was proving that a diversified portfolio can provide the same return as a high-risk investment such as a single stock with a lot less risk. The grey line represents the Efficient Frontier, that is, the investment mix that offers the greatest annualized expected return for any given risk level. Three of the portfolios in the chart have the same expected return, but the portfolio No. 5 has much less risk than the other two.

For nearly all investors, the principal asset classes of choice boil down to common stocks (for maximum total return), bonds (for reasonable income), and cash (for stability of principal) each differs in risk: stocks are the most volatile, bonds are less so, and cash is the least risky of all three.

Portfolio 1 The 100% cash portfolio has very little risk, but its expected return is small.

Portfolio 2 If you are a little more risk tolerant, an all bond portfolio offers a better return than cash, but you have to take some risk.

Portfolio 3 A single stock portfolio has a huge amount of risk for an expected return of say 9% a year.

Portfolio 4 Owning a 30:70 mix between short-term fixed income fund and equity fund also provides an expected return of around 9% but due to diversification, it's far less risky than owning a single stock.

Portfolio 5 is the market risk portfolio, which is made up of 45% bond funds; 65% stock funds. For a 9% expected annual return with only marginally more risk than an all bond strategy in portfolio 2 and less risk than portfolio 3, this is the perfect portfolio with maximum expected return with minimum risk.

Striking your Own Asset Mix

One final thought, whatever asset allocation you pick, make sure it's the one you can live with. There are no easy rules here but a combination of age and asset level provides a sensible proxy. A young person who is just beginning to accumulate capital, with a small amount at stake, is able to take considerable risk, seeking maximum advantage from equity returns and rely on time horizon to iron out volatile short-term returns. An older person who has accumulated large assets has less time to recover possible losses and thus should seek greater certainty, lower risk and sustained income even at the expense of lower capital return.

A four-quadrant matrix below with suggested allocations for older and younger investors who are in different stages of their investment life cycles should provide many of you with a good starting point. The model assumes that, over long time periods, stocks will outperform bonds and stock returns will be less predictable, which are consistent with the historical record.

Basic Asset Allocation Model

        

During the accumulation phase of your personal investment cycle when you have no immediate need for these assets, you can put your capital at greater risk in pursuit of higher return. As a young investor, you might allocate as much as 80% or more of your portfolio in stocks, with the remainder in bonds. As the later years of your accumulation phase begin, you are older and have less time to recoup any decline in the value of your portfolio. At that point, you might want to limit your stock exposure to no more than 70%.

During the distribution phase of your investment cycle, when you enjoy the fruits of your early endavour by withdrawing the income generated by your investments, you can not afford substantial short term loss. At the start of this phase, you might reduce your stock allocation to 60% or so. As you age, you might want to cut it to 50%.

Once you have determined your strategic long term asset allocation, you might want to modify the model's broad guidelines to account for your own financial circumstances, your age, your objectives and your risk appetite.