Building An Effective Investment Portfolio: A Practice Guide

Investment portfolio reviews are a crucial step in achieving financial goals. They help investors assess whether their portfolio is aligned with their financial goals, risk tolerance, and tax efficiency objectives. By conducting regular reviews, investors can identify potential gaps and blind spots in their investment strategies and make adjustments to stay on track. This process involves analysing asset allocation, diversification, risk exposure, management expenses, ownership costs, and tax strategies.

To put together an investment portfolio review, investors should follow a structured process. This includes gathering all financial assets in one place, setting clear expectations, assessing portfolio returns, and studying the constituents of the portfolio. It is also important to acknowledge the client's needs and objectives, provide a comprehensive long-term perspective, establish confidence, and discuss sensible investment opportunities.

Additionally, IT portfolio management (ITPM) practices can be applied to improve the performance of the portfolio by balancing risk and return. This involves managing IT as a portfolio of assets, similar to financial portfolios, and using metrics to measure and increase the return on individual and aggregate technology investments.

By following these steps and best practices, investors can ensure their investment portfolio is well-positioned to achieve their financial goals while minimising risk.

Assess your portfolio returns

The third step in your portfolio review process is to know how the portfolio has performed as a whole. To keep it simple, prepare a single, easy-to-understand percentage that can represent your portfolio’s growth over a period of time.

Calculating your portfolio’s investment returns will give you a better understanding of each asset’s expected gains while gauging consequential factors such as downside risk, market conditions, and the time each investment will take to realise its returns.

To begin, you just need the original cost of each investment and its current value. You can calculate the return on investment (ROI) for each individual asset, which will help you focus on profitable or underperforming investments.

Then, calculate the return for your entire portfolio. You can do this by listing each type of asset in a spreadsheet, along with the ROI, dividends, cash flows, management fees, and any other figures relevant to the cost or returns of those assets.

Time-weighted returns (TWR) and money-weighted returns (MWR) are two standard methods for calculating investment returns. TWR focuses on the portfolio’s investment performance, removing the impact of external cash flows. MWR, on the other hand, accounts for the timing and size of an investor’s contributions and withdrawals.

There are also other ratios you can use to assess your portfolio returns, such as the Treynor, Sharpe, Jensen, and Sortino ratios. These combine risk and return performance into a single value to measure portfolio performance.

Define the benchmark

Benchmarks are an important tool in investment portfolio reviews. They are the standard or measure used to evaluate the performance of a portfolio.

Types of Benchmarks

There are different types of benchmarks that can be used, depending on the specific investments, risk tolerance, and time horizon of the investor. Here are some examples:

• Broad Market and Market-Segment Indexes — These indexes are created to include multiple securities, assets, or other instruments to represent the performance of a particular market or market segment. Examples include the S&P 500 and Dow Jones Industrial Average for large-capitalization stocks, and the Bloomberg Commodity Index for commodities.
• Mutual Fund Indexes — Mutual fund investors may use the Refinitiv Lipper indexes, which are based on the 30 largest mutual funds in a specific category.
• International Indexes — Investors with international holdings may use the MSCI Indexes.
• Fixed Income Indexes — These indexes measure the performance of fixed-income assets like bonds and treasuries. Examples include the Bloomberg Aggregate Bond Index and the Bloomberg U.S. Treasury Bond Index.

Selecting a Benchmark

When selecting a benchmark, it is important to consider the following:

• Performance Goals and Risk Tolerance — Investors should evaluate their return goals and risk tolerance before choosing a benchmark. For example, an investor with a low-risk tolerance will likely select an index with a shorter duration or higher credit quality.
• Need for Liquidity — If an investor needs to meet short-term liabilities or obligations, they will require a highly liquid portfolio and a benchmark with a very short duration.
• International Securities — The decision to invest in international securities will depend on the investor's views on foreign currency exposure and their willingness to take on the associated risks.
• Inflation-Linked Liabilities — For investors with inflation-linked liabilities, such as fixed-income investors, selecting a benchmark that tracks inflation-sensitive assets, such as the Bloomberg Euro Inflation-Linked Index, can be important.
• Range of Securities — The benchmark should allow the portfolio manager to invest in a broad range of securities to potentially increase returns and reduce volatility. However, if the benchmark is too narrow, it may limit the manager's ability to actively manage the portfolio effectively.

Using Benchmarks in Portfolio Reviews

When conducting an investment portfolio review, benchmarks are used to compare the performance of the portfolio against the relevant industry, sector, and market segment. This comparison helps identify whether the portfolio is meeting its financial goals and risk tolerance levels. Additionally, benchmarks can be used to assess the allocation, risk, and return of the portfolio.

By understanding the different types of benchmarks and how to select and use them effectively, investors can gain valuable insights into the performance and health of their investment portfolios.

Track the right metrics

Tracking the right metrics is a crucial aspect of portfolio management. It allows investors to assess the performance of their investments and make informed decisions. Here are some key metrics to consider:

Performance Metrics

• Total Return: This is the most common way to measure the overall returns of an investment and compare it across different asset classes. It is typically calculated over a specific time horizon, such as one year, three years, five years, or ten years.
• Portfolio Return vs. Benchmark: Comparing the portfolio's return to a relevant benchmark, such as the S&P 500 for stocks or the Barclays US Aggregate Bond Index for bonds, provides context for the performance.
• Monitoring Frequency: Investors should define how often they will assess their portfolio's performance, commonly done quarterly.

Risk Metrics

• Standard Deviation: This measures the volatility of an investment or portfolio. A higher standard deviation indicates greater price variation.
• Beta: Beta is a statistical measure that compares an investment's risk to a market benchmark. A beta higher than 1.0 indicates higher volatility, while a beta lower than 1.0 means lower volatility than the market.
• R-squared: This metric represents the percentage of an investment's price movements that correlate with its benchmark index. For example, an R-squared of 0.95 means that 95% of the investment's price movements are correlated with the benchmark.
• Sharpe Ratio: The Sharpe ratio measures risk-adjusted returns and helps investors decide if the additional risk of an asset or portfolio justifies its return. A Sharpe ratio higher than 1.5 is considered good.
• Sortino Ratio: The Sortino ratio is similar to the Sharpe ratio but only considers downside risk, ignoring upside volatility. It is often preferred by investors who believe that large price increases are not a risk.
• Treynor Measure: The Treynor measure, also known as the reward-to-volatility ratio, evaluates portfolio performance by considering both returns and systematic risk (fluctuations in the overall market).
• Jensen Ratio: The Jensen ratio, also known as alpha, measures the excess return generated by a portfolio over its expected return, adjusted for market risk.

It is important to note that not all metrics are equally important, and the choice of metrics depends on the specific investment goals and strategy. By tracking the right metrics, investors can make more informed decisions and optimise their portfolios for better performance and risk management.

Monitor, measure, rebalance

Monitoring, measuring, and rebalancing your investment portfolio is a crucial step in managing your money. If left unchecked, your investments can quickly deviate from your original intentions.

Monitoring

• Regularly check your investments' performance: Compare your investments' performance against the benchmarks you've established to ensure they are meeting expectations. This can be done quarterly or semi-annually.
• Assess risk levels: Ensure that your investments are maintaining the desired level of risk and that your portfolio is well-diversified across asset classes and sectors.
• Evaluate investment costs: Minimise investment costs and fees to maximise returns.

Measuring

• Analyse portfolio components: Understand how each component affects the overall portfolio and each asset individually.
• Consider all related ventures: This includes investments in small businesses or real estate.
• Analyse stand-alone investments: Evaluate each investment in isolation, considering your reasons for owning it, your after-tax cash flows, and whether you should continue holding it.

Rebalancing

• Adjust your portfolio as needed: If your annual review reveals that your portfolio no longer aligns with your risk-reward profile or target allocation, it's time to rebalance.
• Sell and buy investments to restore balance: For example, if your target allocation is 60% stocks and 40% bonds, and market changes have shifted this to 70% stocks and 30% bonds, you'll need to sell some stocks and buy more bonds to restore your original allocation.

By following these steps, you can ensure your investment portfolio remains aligned with your financial goals, risk tolerance, and life circumstances.

Assess risk tolerance

Risk tolerance is a crucial aspect of investment portfolio management. It refers to the degree of risk an investor is willing to accept, given the potential for losses in the value of their investments. Understanding an individual's risk tolerance is essential for planning their investment portfolio, as it determines the types and amounts of investments they choose.

Identify Investment Goals

The first step in assessing risk tolerance is to understand why an individual is investing. Common investment goals include saving for retirement, a child's education, or financial independence. Identifying these goals helps establish the time horizon for the investments and the level of risk that can be taken.

Determine Time Horizon

The time horizon refers to when the investor plans to use the money they have invested. Generally, a longer time horizon allows for taking on more risk, as there is more time for investments to recover from potential downturns. Conversely, a shorter time horizon, such as saving for a house down payment, requires a more conservative approach to risk.

Evaluate Comfort with Short-Term Losses

It's important to consider how comfortable an investor is with potential short-term losses. Investments can fluctuate, and stocks may decline in value. If an investor needs their money in the near term, they may be forced to sell at a loss. Those with a longer time horizon can hold on to their investments, giving them a chance to recover and potentially increase in value.

Assess Non-Invested Savings

It is advisable for investors to have some savings set aside in liquid accounts, regardless of their risk tolerance. This provides a safety net in case of emergencies. However, if an individual is keeping a large portion of their savings in cash due to a fear of investing, it indicates a risk-averse attitude.

Understand Monitoring Frequency

Another factor influencing risk tolerance is how frequently an investor plans to monitor their investments. Some individuals may anxiously track their investments daily, while others may check them semi-regularly. If market downturns cause anxiety, a diversified portfolio and a long-term focus can help. On the other hand, those who actively seek new investing opportunities may be more willing to take on risk.

Utilize Risk Tolerance Assessments

Online risk tolerance assessments, surveys, and questionnaires can be valuable tools for determining an individual's risk tolerance. These assessments consider factors such as age, financial goals, income, and investment experience to provide a comprehensive understanding of an investor's risk tolerance level.

Review Historical Returns

In addition to assessments, reviewing historical returns for different asset classes can help gauge risk tolerance. By examining the volatility of various financial instruments, investors can make more informed decisions about the level of risk they are comfortable with.

Consider Other Factors

Other factors that influence risk tolerance include an investor's future earning capacity and the presence of other assets, such as a home, pension, or inheritance. Investors with more stable sources of funds or a larger portfolio may have a higher risk tolerance, as they can afford to take on more risk without jeopardizing their financial stability.

By following these steps and considering individual circumstances, investors can effectively assess their risk tolerance. This, in turn, will guide the construction of a well-balanced investment portfolio aligned with their financial goals and comfort level.

Frequently asked questions