LONDON, 28 February 2005 — Investors often worry persistently over which mutual funds to buy, what percentage to allocate to stocks and bonds, and how much should be invested outside their own countries and in what currencies. These issues, albeit important, are not the main criteria to building a great portfolio. So what is it.
I believe it boils down to one simple approach: No matter what investment mix the investor own, there is a need to set targets for what percentage to invest in each sector, and thereafter need to stick to these percentages, come what may.
I know too many people who invest backward. How? They hear about a hot stock, so they buy it. Then they read about a top-performing equity fund, so they buy that as well. As so it goes on and on with people buying one investment after another, never giving much thought to whether they have the right mix of stocks, bonds, etc.
In order for an investor to do it right, he should first start by writing down why he is investing. Then, based on his goals and appetite for risk, decide how to divvy up his money between, for example, stocks and bonds.
The next step is to make a list of the stock- and bond- market sectors to invest in. Then include the percentages allocated to large stocks, small companies, foreign shares, real estate investment trusts, high-quality US and others bonds, and whatever other “fancy” products. This is basically the framework for a portfolio.
Having sketched out this framework, it would then be a process of selecting or deciding on which stocks, bonds and mutual funds etc., to buy and fill each slot in the portfolio.
The result: Instead of a mixed bag of investments, the investor will have a reasonably rational portfolio.
My advice to the investor: When you draw up your target portfolio, be careful not to allocate an uncomfortably large amount to any one sector. For instance, I often suggest dividing a stock portfolio so that there is 70 percent US stocks, and 30 percent in other non-US shares. But the precise split is not that critical. True, you want to have a degree of diversification by owning both US and other stocks. You may decide, however, that you are more comfortable with a different mix.
The important thing to always remember as you go through this exercise is the anticipated “positive” returns on your investments.
However, you will not be able to realize those returns if you do not stick with your stated targets. The danger is when you invest too heavily in one sector, panic when it tumbles and end up selling it at a steep loss! When this happens, you need not to panic but, in fact, you should be seizing the opportunity and start a rebalancing process.
Generally speaking, a portfolios needs to be rebalanced every year or so to bring it back into line with the target percentages. By doing so, rebalancing will keep a portfolio’s risk level under control and can also boost returns. One would query: A higher return with reduced risk?
It’s worth remembering that rebalancing stops you from becoming overweight in any one sector, thereby controlling risk. Not only that, it would also forces you to cut back on highflying sectors that may be due for a relapse, while adding to those that are depressed and could be ripe for a rebound. Over time, this tends to enhance and bolster performance.
You can rebalance by selling out hot investments and shifting the proceeds into sectors that are lagging behind. However, keep in mind that selling what’s popular and buying what’s not takes a strong stomach.