A few weeks back I talked about three essential steps in building a mutual fund portfolio. I’ve had a few questions from readers and would like to expand on the topic of developing a mix.
Start with Modern Portfolio Theory (MPT)
Modern Portfolio Theory is the philosophical opposite of traditional stock picking. It is the creation of economists who try to understand the market as a whole, rather than business analysts who look for what makes each investment opportunity unique. Investments are described statistically in terms of their expected long-term return rate and their expected short-term volatility. The goal is to identify your acceptable level of risk tolerance and then to find a portfolio with the maximum expected return for that level of risk.
Your basic asset classes
When developing the right mix, the first place to start is with your three basic asset categories – stocks, bonds and cash. Each asset category has a basic level of risk with an expected return.
- Cash is the most conservative asset class and is usually measured as Treasury bill rates. Currently cash is paying less than 3% but with no risk.
- Bonds will typically provide higher returns than cash but can also be a little more volatile. If you go back as far as 1924, bonds have provided an average return of about 6.4%. The Bond category can also be broken down into short term bonds, mid term bonds and long term bonds.
- Stocks as everyone knows today carry a high level of risk. However, given time, they also provide the highest returns. In fact, the average return since 1924 for Canadian Equities is 12.0%.
The bottom line, is the more conservative you want to be, the more likely you are to have heavier weightings of cash and bonds. The modern portfolio theory states that by mixing these three basic asset categories you can develop an optimized level of risk and return. In other words, efficient allocation of assets means that you can determine the highest returns given a certain level of risk. The chart used to demonstrate the efficient allocation of assets is the efficient frontier.
Adding other variables to the mix
After you have made decisions about your basic asset categories, you can then add other dimensions. The more dimensions you add, the more comprehensive efficient frontier you will have. I will highlight some of these classes:
- Geography. We live in a global world where it has become easier to invest anywhere in the world. Adding geography to your mix means that you want to diversify your holdings around the world. Instead of just Canadian Markets, you could add the US market, the Japanese market, European markets and emerging markets.
- Capitalization. The stock market is generally broken down into three different sizes of stocks. Everyone’s definition differs, but here is a general-purpose breakdown of market capitalization categories:
- Giant cap. = over $25 billion
- Large cap. = $5 billion to $25 billion
- Medium cap. = $1 billion to $5 billion
- Small cap. = $250 million to $1 billion
- Micro cap. = Under $250 million
- Sector Breakdown. Stock markets are not only categorized by their geography and capitalization but also by sector. The stock market consists of different sectors like technology, resources, financial services, health sciences, etc. Every sector goes in and out of favour so having different sectors in your portfolio is a very important aspect of risk management.
- Management Style. If you are buying mutual funds, you must account for differing management styles. The two main types of styles are Value and Growth and to keep this description brief, suffice it to say that different styles will go in and out of favour. Today, there are many different hybrid styles and many would argue that style diversification has become increasingly important.
Harry Markowitz and William Sharpe both won the Nobel Prize in Economics for their work on the Modern Portfolio Theory. It has become one of the most fundamental theories behind portfolio design and investment management. As mentioned before it incorporates more of a global top down perspective to money management and does not account for individual stock selection. Those who believe in MPT say that basic asset allocation accounts for 90% of the reason behind investment return.
A final word of caution
I have a strong belief in the Modern Portfolio Theory, and asset allocation, because it adds a scientific dimension to an imperfect science. However, allocation models and research can vary dramatically depending on what information you use, what time frames you use and also how many asset categories you use. Try not to put all your faith in one model.