“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffett
Much advice is available on how to become a successful investor. Some suggestions are useful while others are less so or even counterproductive. For example, here are a few other quotes from Warren Buffett,
- ‘The first rule is not to lose. The second rule is not to forget the first rule.’
- ‘Risk comes from not knowing what you’re doing.’
- ‘Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.’
- ‘For some reason, people take their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up.’
- ‘Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.’
The world of investing can be cold, hard, and unforgiving. But if you do thorough research, avoid cognitive biases, and follow some straightforward but effective guidelines, you can improve your chances of long-term success. Our purpose is to provide several key elements that can help you develop a successful portfolio strategy and therefore avoid some pitfalls in investing.
What is Portfolio Strategy?
Simply put, portfolio strategy is a roadmap by which investors can use their assets to achieve their financial goals. Portfolio theory refers to the design of optimal portfolios and its implication for asset pricing.
Starting with the work of Markowitz (1952, 1959) and his mean-variance framework based on expected utility theory, portfolio theory has undergone rapid development. The evolution of capturing the risk-return tradeoff provides the engine for this development. The classic capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965) predicts that an asset’s risk premium will be proportional to its beta, which is measure of return sensitivity to the aggregate market portfolio return. Subsequent evidence against the CAPM points to the fact other factors market-portfolio proxy must be considered in explaining aggregate risk.
Investment Guidelines: The Investment Policy Statement
Each person’s financial circumstances are unique. Professionals working with private wealth clients often construct an investment policy statement (IPS) to better understand their clients’ goals. An IPS specifies the client’s risk and return objectives along with relevant constraints. Liquidity needs and taxation are especially important constraint considerations. The portfolio asset allocation is a function of the IPS. Retirement planning and estate planning are also part of the process.
1) How Much Risk Can An Investor Tolerate?
Investor goals should consider both return objectives and risk tolerance. A basic finance tenet is that a tradeoff exists between risk and return, which is fundamental for investment choices. That is, an investor who requires a higher return can expect to incur greater risk.
Traditional finance theory assumes the most investors are risk averse. Investor psychology is also important to consider in the context of assessing risk tolerance. Kahneman and Tversky’s (1973, 1979) develop prospect theory, which is a theory of decision making under conditions of risk. This theory, which is the most widely used alternative to the expected utility theory, find inconsistencies in investor choices when faced with potential gains versus potential losses.
That is, people value gains and losses differently and, as such, base decisions on perceived gains rather than perceived losses. Investors typically are not only more concerned about losses than about gains but also are risk averse over gains and risk seeking over losses. Assessing risk tolerance is essential in advising clients about portfolio options. An investors’ risk aversion or its inverse – risk tolerance – is a key factor in determining the optimal portfolio selection.
2) Establishing the Appropriate Asset Allocation
For traditional portfolios such as those consisting of stocks and bonds, the choice of asset classes is a critical element differentiating portfolio performance. Inappropriate asset allocation decisions can detract from longer-term performance. Asset allocation strategies can occur strategically and/or tactically. Strategic asset allocation takes a longer-term approach to capital market expectations, while tactical asset allocation has the potential to add value by seeking out shorter-term opportunities. In addition to asset allocation, actively managing a portfolio involves two other activities: asset selection (selecting specific assets to match the allocation target), and market timing (deciding when and how much to invest). More recent research indicates that asset selection may be as important as asset allocation with market timing a distant third.
3) Portfolio Rebalance: A Cost/Benefit Analysis
Portfolios require rebalancing periodically to restore asset allocations based on the IPS and to make changes based on client circumstances. Managers must consider the tradeoff between transaction and monitoring costs and the costs of not being at the optimal allocation (tracking error). Managers should try to achieve “best execution” of trades for the clients. Decision on setting parameters for rebalancing portfolios should consider the possibility for asset classes to exhibit best results. A good portfolio rebalancing activity can significantly add to the returns while not changing the portfolio construct drastically.
4) Portfolio Performance Measurement
Assessing portfolio performance requires selecting an appropriate benchmark. Benchmarking is a reference that reflects a comparable style to that of the portfolio to be followed by the manager. As a tool for measuring relative performance, benchmarking helps to assess the manager’s skills regarding market timing and security selection. Selecting the appropriate benchmark allows for a more accurate measurement of performance. Establishing a meaningful benchmark is crucial to those involved in selecting and evaluating investment funds and for those studying the risk-return profiles of those funds. These funds are often classified based on a particular investment style. Investment styles are groups of portfolios sharing common characteristics that behave similarly under a variety of conditions. Style can be distinguished on two metrics: portfolio holdings and portfolio returns. A more appropriate analysis of risk occurs when investors or their advisors take investing style into consideration.
In India, Nifty or Sensex return is widely used as a benchmark to understand the portfolio performance.
5) Market Innovations
Market innovations allow investors to alter asset allocations synthetically or to gain exposures to niche strategies and non-traditional investment options. Risk can be altered by using derivative securities such as futures and options. Investors often fear derivative securities because they do not understood or misuse them. However, derivative securities allow investors to augment or reduce risk to a given asset class or in the overall portfolio. Another innovation is exchange traded funds (ETFs), which are one of the most successful financial innovations since the 1990s. ETFs often provide a more efficient means of obtaining diversified exposure to a wide-variety of asset classes and strategies than mutual funds.
Increasingly, investors are taking an interest in non-traditional investments. These opportunities are often classified as alternative investments and include hedge fund and private equity. Because hedge fund return properties differ from those of traditional asset classes, enhanced portfolio optimization approaches are needed when considering hedge funds in mixed-asset portfolios. Investors can obtain private equity exposure through closed-end limited partnership funds, but such funds typically do not provide much liquidity. Venture capital, which is one type of private equity, provides entrepreneurial businesses with substantial capital in the startup phase.
Portfolio Management: A Dynamic Process
In this article, I tried to provide a framework by which investors (often through professional managers) can establish a successful portfolio strategy. Developing an investment strategy starts with formulating an IPS. Measuring performance, benchmarking that performance to an appropriate metric, monitoring performance over time, and rebalancing a portfolio as needed are essential elements in keeping portfolios appropriate based on the dynamic nature of the markets and ever-changing investors’ needs. Market innovations offer new and exciting opportunities to achieve goals and enhance risk-adjusted performance over time. Finally, you don’t need to be a genius to have a successful investment strategy.
As Warren Buffet said, “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”