By Victor Yan and Henry Yu
- The Concept of Diversification
- Diversification & Portfolio Allocation
- Portfolio Allocation for Passive Investors:
- An Introduction to the Active Investor
- Tactics for an “Active” Portfolio
- The Activist Investor’s Portfolio Strategy
Continuing UNIT’s series on personal finance, this time we’ll combine the knowledge of financial instruments learnt over the past weeks into a big melting pot called “Portfolio Allocation”. After all, investments are not of a binary nature that suggests that you must own either this particular instrument or that, and for good reason as a well-designed portfolio can help you minimize risk and optimize your expected returns as this article aims to demonstrate.
The Concept of Diversification
One of the core principles of passive investing is investors with a widespread asset take a much lower risk then those who just hold one asset. To maintain a steady growth rate and fully enjoy the magic of compounding, you need to ensure you don’t put all eggs in one basket, as the market will not reward investors who don’t diversify.
Illustrating this example with sports, anyone familiar with the recent Golden State Warriors dynasty has witnessed a prime example of portfolio allocation and diversification at work. With a star-studded team including the likes of Stephen Curry, Klay Thompson and Kevin Durant for their offensive scoring load, the Warriors didn’t have to worry about overleveraging on one player to perform spectacularly each and every game. For example, Curry and Durant may have an off-scoring but Thompson might catch on fire that same game to compensate for their scoring.
Diversification and Portfolio Allocation
Now applying this to a financial scenario, imagine you have $100,000 to allocate towards investments with two choices:
Choice A: Invest all $100,000 into Qantas stock (Airline Industry)
Choice B: invest $50,000 into Qantas stock (Airline Industry) and the other $50,000 into Newcrest Mining stock (Mining Industry)
While you might be bullish on Qantas stock and expect it to perform better than Newcrest, there are no “guaranteed returns” in the market – and there is always a possibility that an event occurs that may send Qantas shares diving (eg. Adverse change in aviation regulations). Thus, it makes sense to “spread your bets” across different securities with different correlations similar to choice B, where bad news for the aviation industry might be counteracted by good news in the mining industry.
Extending this analogy, while these two stocks might be weakly correlated against each other, they still tend to be positively correlated to the equity market. Thus, one might argue that an equity market crash will lead almost most stocks to fall. After all, both Qantas and Newcrest have been adversely hit by the COVID-19 crisis. Thus, diversification should extend not only between stocks, but also various financial instruments. For example, bond securities, gold or currencies such as the Japanese Yen tend to be negatively correlated to the stocks, and diversification into these instruments for portfolio construction might make sense for the investor who doesn’t want to bet all his earnings purely on stocks.
In general, there are a few “dimensions” of diversification the investor should consider:
- Diversification between stocks by their market cap (eg. Blue chips and small caps)
- Diversification between stock by their industries (eg. Aviation stocks and mining stocks)
- Diversification between instruments (eg. Stocks, bonds, commodities, currencies)
- Diversification between geographies (eg. Asian equities and Australian equities)
However, with tens of thousands of stocks to choose from, how do you go about selecting ten, twenty companies worth buying? Well, we can simply start by deciding what you want to achieve, how much time you are ready to put in for investing and the level of risk you are willing to bear. Therefore, it comes down to asking yourself a more fundamental question: passive or active investing?
Portfolio Allocation for Passive Investor
The Magic of Compounding Interest
A passive investor does not try to beat the overall market, rather they are market participants who trust in the fact that over the long-run stock market goes up. You are not required to put in a huge amount of time to find best companies to get the highest possible return. Conversely, what you need to do is to buy and hold, letting the compounding effect do its work. Here’s a graph of S&P 500 since inspection in 1927.
Over the past 93 years, the market index gives an annualized return of approximately 10-11%. What this means is if you put 10 dollars in the US stock markets in 1927, it is going to be worth $70,716.33 today! If you remember from ‘What is Investing’ by UNIT, the great Albert Einstein once said, “Compound interest is the eighth wonder of the world”. Passive investors could easily outperform knowledgeable, talented fund managers only with a well-diversified portfolio.
What to Choose?
However, what is the optimal portfolio which gives the lowest risk? Well, the answer is basically a broadly diversified portfolio reflecting the market of securities that are available – the Market Portfolio. Luckily, for passive investors, you don’t need to construct one by purchasing every single investment option one by one, instead what are known as ETFs (exchange-traded funds) can be purchased to mimic the market index.
The strategy couldn’t be simpler. Invest the same amount of money in the same stock or mutual fund at regular intervals, say monthly. Ignore the fluctuations in the price of your investment. Whether it’s up or down, you’re putting the same amount of money into it. By doing so, your portfolio will have a return that closely tracks the overall market.
Exchange Traded Funds are obviously one of the best investment options for passive investors. It saves you time, effort and brainpower while bringing a tasty return. But keep in mind, it is not perfect and certainly not risk-free. Not every ETF traded will replicate every security traded on the market. In fact, one ETF usually only covers a few hundred securities in a specific market or industry.
For example, Vanguard Australian Shares Index ETF (ASX: VAS) only covers the top 300 companies listed in Australia, so it is not going to eliminate all diversifiable risk. Think about it, if there is a disaster affecting all Australian companies, the entire Aussie market will be impacted.
Thus, one good idea is to allow your portfolio to be diversified enough across different industries, geographical markets, and even types of instruments (i.e. stocks, bonds, properties, etc.) to ensure minimized risk and steady return.
Some Portfolio Allocation Models
As the saying goes, “you’ve got to play the game first in order to win”. Thus, no discussion of returns or performance is meaningful without at least some mention of the risk involved. Keep in mind, there will always be trade-offs between risk and reward. As an investor, you need to think carefully of your risk tolerance, then to build a portfolio upon the level of risk you are willing to take.
For example, an instrument in bonds pay investors a regular income, and their prices are much less volatile than those of stocks, but it also means investors will also be expecting a lower return. Adjusting your portfolio by changing the mix of stocks and bonds could be a good strategy to control the overall risk for your investments.
Here, the charts above illustrate how different allocation models could impact an investor’s risk and return. With 60% of bonds, the portfolio has lower risk than the other two, with losing only 18.4% in the worst year. However, the tradeoff is also clear, a 7.4% return compared to 8.6% for “40% bonds-60% stocks” portfolio. That being said, there is no “right” portfolio, only the most “suitable” portfolio tailored to your needs and risk tolerances. As an example, it is generally advisable for younger people to take on more risk by allocating more capital to riskier equities, as they are able to bear the brunt of falling stock prices with their regular income. Meanwhile, a retiree may be more risk-averse as they are not earning regular income and may be more attracted towards a low risk portfolio consisting of stable dividend flows from conservative equities and bond instruments.
For those who are further interested in portfolio design, https://portfoliocharts.com/portfolios/ is a good source to view commonly used portfolio allocations, as well as self-design your own and examine its risk/return profile across various parameters.
Portfolio Allocation for Active Investors
An Introduction to the Active Investor
With the core concepts of portfolio allocation detailed, as well as strategies for the passive investor, we can investigate portfolio allocation applicability for those who identify as “active investors”.
One might ask, what is an “active investor”? These are the categories of investors antithetical to the “passive investor”. While passive investors mainly execute a “buy, hold and forget’ strategy that emulates returns of the market, active investors subscribe to the goal of beating the market benchmark – devoting their time, resources and expertise into finding specific investments that will help deliver superior returns (In fact, actively investing as a job is simply called being a fund manager).
In essence, the first principles of portfolio allocation and diversification are universal and thus applicable to the active investor’s considerations – it is just typically the case the active investor will have a greater array of options and control to achieve this diversification.
Tactics for an “Active” Portfolio
For one, some will regularly monitor current financial and economic market conditions (eg. inflation, interest rates, geopolitical risk) to gauge where the risks are concentrated and will actively adjust their portfolios correctly to minimize their “perceived risk”. One general strategy could be to actively change your portfolio weightings when anticipating a dramatic change in market risks.
For example, imagine if I started out with a simple 50/50 allocation between stocks and bonds. After a year passes, I start fearing of a potential equity market crash and thus could take an active approach to limit this risk – potentially selling off some of my equity stock and reinvesting them into bond instruments to achieve a 25/75 allocation between stocks and bonds eventually (this now exposing only 25% of my portfolio to the stock market).
Another active investor’s tool can be the frequent use of hedging instruments to control risk. Here, hedging entails taking on a position that protects yourself against adverse movements in a currently held position.
While this may appear an advanced concept on the onset, hedging occurs all throughout our daily lives. Think of the insurance you bought for your car – your motivation being to protect yourself from paying the full cost of repairs in case you do crash.
With this in mind, let’s illustrate an example where you bought shares in Samsung knowing that they are in the final stages of developing a patented phone that never runs out of power, thus expecting a huge share price spike for your Samsung shares upon the patents completion.
However, let’s say the phone comes out a week before the general stock market crashes. While the news of Samsung’s new patent is undoubtedly good for the company, it is perhaps insufficient to override the bearish sentiment of the stock market, thus overall tanking Samsung’s stock price.
While there are several ways to hedge against the overall “market risk”, one such way could see the activist investor buy Samsung shares and short sell Apple shares. This thus controls for the market risk in your position such that if the market indeed tanks, your Samsung shares might fall by only 4% as it is partially lifted up by its patent announcement, while Apple shares fall in line with the market to a much greater magnitude of say 15%. As you have shorted your Apple position, you’ll make a 15% profit off Apple’s price drop and in tandem with your Samsung position, combine for a net return of 15-4%=11%. Using this logic towards your individual positions, the active investor can utilise a series of complex hedge instruments in order to adjust and limit their risk exposure to their own tolerance at any moment they perceive a change in risk.
The Activist Investor’s Portfolio Strategy
Finally, the expertise and effort by the active investor may see them take on certain actions that are either unadvised or unachievable by their passive counterparts. For example, there is a class of active investors commonly termed as “activist investors”. In these cases, activist investors look to secure a large equity stake such that they can exert considerable influence towards the management of the company. From here on out, they can sway company decisions with their voting power in order to “de-risk” their current position consistent to what actions they think would help the company lift their share price.
The Intelligent Investor by Benjamin Graham (originally published in 1949).
Other Video Sources:
Other Related UNIT Articles:
- ‘What is Investing’
- ‘Introduction to Stocks’
- ‘Introduction to Bonds’
- ‘Introduction to Property’
- ‘How to Invest’
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.