101: Guide for creating an investment portfolio
So, you want to put together an investment portfolio or a you may already have one but are unsure if you are maximising your opportunity.
We can only speak in general terms however the examples we talk about here elude to the underlying fundamentals of portfolio construction. The real benefit for you is how to maximise return with a level of risk that suits your appetite.
Now let’s talk about the constituents of a typical portfolio.
As mentioned before there are many investments that can make up portfolio (managed funds, ETFs, LICs, stocks, property, bonds etc). At the beginning of our lives we tend to focus on property, as we all look for the Australian dream of owning our own home. As we move through the stages of life an investor may look to place discretionary funds into various other investments; investment property, managed funds, play the stock market, try their hand at options or Forex trading.
However, a well-constructed portfolio should have a diversified range of assets. For example, in Burton G Malkiel’s book, A Random Walk Down Wall Street, he exemplars two investments; one is a company that sells umbrellas, the other is a beach holiday resort. If the season is warm the resort returns 50pc and if raining return loses 25pc. Conversely, if the season is raining the umbrella company returns 50pc and if warm loses 25pc.
In the scenario, an investor can punt on the weather and experience boom or bust on an individual investment. However, Harry Markowitz’s Modern Portfolio Theory suggests diversification between the two can return 12.5pc on either weather outcome.
The key to this is to diversify in uncorrelated investments.
"Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero. But financial engineers should know that's not true of a portfolio of correlated risks."
Harry Markowitz - Modern Portfolio Theory
Now let’s talk about correlation:
Correlation is a statistic that measures the degree to which one asset moves in relation to another. this measure is calculated to what is called a correlation coefficient and ranges between 1 and -1.
1 means positively correlated, 0 uncorrelated and -1 negatively correlated.
Let’s put this into a real-world example: take the below two investments 1, Melbourne Median House Price change between 2010 -2016 compared to SYI - SPDR MSCI Australia Select High Dividend Yield Fund, a popular index tracking ETF. The correlation coefficient between the two is -0.0466 which is almost 0. This can then be accepted as an uncorrelated investments and would work well in a portfolio.
Building a correlation matrix of investments or asset classes can help an investor design a portfolio so to not stack correlated assets. This can be done yourself by looking at the returns of the investments. See below for an example:
XJO - ASX 200 Index
MHP – Melbourne Median House Prices
SYI - SPDR MSCI Australia Select High Dividend Yield Fund
HGL – Jackson Capital Hedgling Managed Discretionary account
VAS - Vanguard Australian Shares Index ASX300
Where is the sweet spot?
We have now learnt that when considering investments for a portfolio, risk and return are not the only elements to study. The correlation between each of the investment is also required to protect against specific and sector risk. So, what should you be looking for? We suggest look for correlations between -0.5 and 0.5. Then of course, make sure the risk and return fit your investment profile.
Go to last section: How can I Manage Risk and Return in my Portfolio?