The easy way to construct an investment portfolio

2012-09-08 10:23

Investors today are confronted with an array of investment options and funds to choose from when constructing an investment portfolio.

Coupled with the wide choice of available funds, investors’ emotions can also get in the way of making an appropriate investment selection.

By following a structured approach, investors can simplify the fund-selection process and avoid emotional decision making.

1 Determine your risk profile
Investors generally fall into one of five risk profiles – conservative, cautious, moderate, moderately aggressive or aggressive – according to how much equity (shares) exposure they’re willing to take on.

An investor’s level of satisfaction with the investment is closely linked to whether it is in line with his or her risk profile.

Higher risk generally means higher returns, so an aggressive investor probably won’t be satisfied with the returns from a conservative investment portfolio.

It’s important to consider not only how much risk you’re willing to take, but also how much risk you can afford to take.

Investors typically fear losses more than they anticipate gains.

It’s therefore necessary to be comfortable with your portfolio’s level of equity exposure.

Investors can, however, generally take on more risk if they’re investing over the long term as the impact of
the volatility will be smoothed out over the term of the investment.

2 Strategic asset allocation
Strategic asset allocation involves allocating a percentage of the investment amount to each of the main asset classes: cash, bonds, equity, property and offshore assets based on one’s risk profile.

Therefore, a conservative investor will have less exposure to growth assets, such as equities, than a more aggressive investor.

All investors, regardless of their risk profile, should have at least some exposure to all of the asset classes.

Investors who stick to a diversified portfolio tend to do better over the long term.

3 Tactical asset allocation
Tactical asset allocation takes cognisance of the investment environment and the relative value of the various asset classes.

Once the strategic asset allocation process is done, investors can increase or decrease their exposure to different asset classes within the range of their risk profile based on the market valuations or economic conditions.

Investors can select asset-allocation funds within their risk profile where the asset managers will make the decision on whether to increase or decrease exposure within a particular asset class.

4 Fund selection
Only now is the investor ready to make a fund selection.

International research shows that strategic asset allocation accounts for about 90% of the portfolio’s long-term return.

Therefore, selecting the correct fund for your long-term objectives is an important determinant of the overall success of the portfolio and a qualified financial intermediary will be able to assist investors to identify appropriate funds suited to their risk profile.

5 Constructing the portfolio
Once the actual portfolio has been constructed, it can be tested against the investor’s risk profile and investment objectives.

At this stage, it’s also important to ensure exposure isn’t confined to a single sector of the economy, such as mining or financials.

This ensures a balanced approach and cushions against market events that could adversely affect a particular sector of the equity market.

6 Monitoring the portfolio

A risk profile is not cast in stone, it changes over time owing to changes in an investor’s personal financial circumstances.

When it changes, the strategic asset allocation should change as well.

Monitoring the portfolio also means rebalancing the asset class exposure when required.

Market movements can cause exposure within the asset classes to move outside the strategic asset-allocation bands due to one class performing better or worse than another at a particular point in time.

For example, in the late 2000s when the equity market had risen dramatically, many moderate-risk investors may have found their exposure to equities was higher than was prudent, given their risk profile.

By rebalancing to reduce their risk, they may have softened the blow of the 2008/9 market crash.

Also important when reviewing the portfolio is to pay attention to the performance attribution generated by the various funds.

For example, are your funds performing as expected and in accordance with their mandate and objective?

Investors are encouraged to consult with a qualified financial intermediary who can provide objective advice
as it’s not always easy.

In addition, using the services of a financial intermediary brings discipline to the planning process.

Glacier provides assistance and support to intermediaries with the above process through various publications and software tools.

» Preston is a business development manager at Glacier by Sanlam


Your choices must be driven by the risks you are willing to take on, writes Clive Preston

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