arty’s advice for investor portfolios in 2021
Let us divulge some guidelines and best practices that should be considered while constructing an ‘efficient’ portfolio. Below we will list a couple of things to keep in mind.
An essential precept in investing decisions is: ‘Don’t look back!’. Remember that ‘past performance is not indicative of future results’, if a security has seen a dramatic price increase, you’re probably too late to reap similar gains.
There is, however, a noteworthy new financial concept in Europe – A, B, C allocations.
A, B, C portfolio
In the following, we will show an easy way to build your own: A, B, C portfolio. But before that, we should mention that there is no dogma in portfolio investment. Many decent varieties exist. In cuisine, Gordon Ramsay and Jamie Oliver will cook differently, but each one of their dishes will be good in its own way.
The principles behind A, B, C allocations are:
– Eliminate the reliability of performance on luck, and replace the latter with a competitive systematic approach. At longer intervals, sophisticated systematic approaches have proven to outperform prophetic investment techniques.
– Remove the emotion from investing.
– Investment returns are highly correlated with the indices in which they are featured.
– Your investment strategy actual result should be evaluated on a long time interval.
– Careful and periodical portfolio rebalancing is essential.
– We should always consider volatility and what will happen with our portfolio in case of a stock market crash (yes, these do happen).
Construct a ‘model’ portfolio
First, we need to understand the conservative component of our portfolio. Let us set this at 60%. We continue by choice of investment currency. Then we look into the investment opportunities in said currency. Those in fixed income, that is, good quality bonds or ETF’s featuring portfolios of such bonds.
Secondly, we need to understand what volatility of returns we can tolerate. Let’s say these are 20%. The “C” component of our portfolio has been set at 60%, under a hypothetical 3% p.a. Consequently, 3%*60% = 1.8% is our volatility reserve.
Thirdly, the A, B components need to be chosen concerning the Sharpe ratio. If the Sharpe coefficient of the S&P 500 is at 0.5 (over the last 12 months), and the coefficient of the alpha-component (explained in detail in our previous posts) is 1.5, then the proportion allocated to A and B components should be 3:1. In our case, A-30% and B-10%.
We go on by checking our allocation with our maximum tolerable volatility (20%). Let’s imagine that you chose component A with 30% volatility and B with 16% (roughly the volatility of the S&P 500, in standard market conditions). Then the total volatility of your portfolio is: VOL = 30%*30% + 10%*16* – 1.8% (our volatility reserve) = 8.8%. Note that we are well within 20%. If you would like to augment the risk taken, you can allocate less to the C (“safe”) part of your portfolio and repeat the given process (allocating more to higher-yielding components).
In our example, your portfolio allocation looks as follows:
A – 30% in alpha strategies with a Sharpe of 1.5 and annual volatility of 30%.
B – 10% in “Beta” driven strategies (basket of stocks, index ETF), with a 16% annual volatility of returns.
C – 60% portfolio of good quality bonds or ETF’s tracking similar securities (relatively safe investment).
A final question remains: where to find such securities?
The simple answer is, ask your broker.
Remember that a regular portfolio rebalancing is required and can add 15-20% to your annual returns.
Let us end this post by reiterating that the methodology described above is one of many investment strategies. Its advantage rests in its simplicity and the deviation from luck-driven investment returns.