The art (and science) of constructing investment portfolios


The art (and science) of constructing investment portfolios

The recent press coverage on Neil Woodford’s investment portfolios (find a typical article from The Guardian here), has reminded us all that making consistent investment returns is not as simple as it may seem.  

At its core, you are trying to buy assets that will be worth more later than it cost you to purchase them. Sometimes you are only interested in the increase in the share price, but for others it will be the combination of income and a rise in capital value that makes an investment worth having. 

Selecting which assets to hold or sell, and which to avoid in the first place, has always been a complex problem. Traditionally, fund managers have selected a basket of investments and sold the rights to capital and income to retail investors, but over time economists and mathematicians have noticed that performance has not been as good as you might reasonably expect, especially after accounting for charges. 

As a wild generalisation, most fund managers will underperform a given market, especially as their direct costs and fees will be a drag on the ultimate investment return. Digging through the research on investment returns has produced the idea that stock picking (this is looking for the “right” shares and buying only them), is ultimately hard to consistently do over the long term. Fund managers may obtain a temporary advantage, by having a better statistical model or better information, but in the long term their performance may return back to the average or market. 

Modern Portfolio Theory earned Harry Markowitz a 1952 Nobel prize in economics. This suggests that diversification is a way of reducing risk by holding assets across sectors, asset types and geographical markets. Various critics suggest that this is not a realistic way of looking at the world, as the assumptions necessary are too general, but it does offer a solid basis for some more specific choices in fund selection. 

The key metrics for a successful investment return are considered these days to be “time in the market”; diversity; and a suitable level of volatility. Stock picking is considered much less important than it once was. The practical outcome for an individual investor is to: 

  • Invest as much as comfortably possible, as soon as possible, without running short of cash to meet day to day expenditure. 

  • Diversify the investment holdings; get advice to avoid putting too many eggs in one basket. 

  • Ensure your portfolio is designed around your Attitude to Investment risk; ensure that you are not taking more or less risk that you are truly comfortable with. 

  • Ensure that the diversification is across asset types, geographies, sectors and time periods. Advised portfolios are usually more highly diversified than self-selected ones.

  • Use tracker funds where the market is considered mature and information is readily available.

  • Use managed funds where the market is specialised, and an expert may achieve an advantage with specific knowledge.

  • Using an adviser is worth around 3% in increased returns according to a research study by Vanguard, by concentrating on helping you understand your Attitude to Investment Risk, asset allocation, low cost fund management, compliance to the model and behavioural coaching. 

  • Manage cash to ensure that you never have to quickly sell an investment at a time which is not ideal within the market.  

True diversity can be hard to achieve; the size of the UK listed market means that although there are a lot of UK unit trusts, they will often duplicate holdings, so lots of unit trust managers does not necessarily equate to a diverse holding. 

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About Martin-Redman Partners    

We are a team of experienced Financial Advisers who can advise on your personal or business financial arrangements. We have been building trusted relationships with clients for many years by articulating clear and tailored recommendations in areas ranging from investments to retirement planning, to complex estate planning advice.   

The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly, no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.