Testing Your Investment Portfolio: Strategies For Success

Testing your investment portfolio is a critical part of managing and monitoring your assets. It involves evaluating the performance of your investments to ensure they are meeting your financial goals and risk tolerance. There are various ways to test your portfolio, including using performance measurement tools such as the Treynor, Sharpe, and Jensen ratios, which combine risk and return into a single value. Additionally, portfolio backtesting can be done by simulating investment strategies using historical data to analyse risk and return. Mobile investment apps and portfolio management software can also help track investments in real-time, providing easy access to information and performance measurements. Testing your portfolio helps you stay engaged with your holdings, track progress towards investment goals, and identify when it's time to rebalance your assets.

Check your asset mix

Checking your asset mix is a crucial part of testing your investment portfolio. Here are some detailed instructions and considerations to help you through the process:

Firstly, it's important to understand what an asset mix entails. The asset mix, or asset allocation, refers to the breakdown of different types of assets within your portfolio, such as stocks, bonds, cash, and real estate. Each of these asset classes plays a unique role in a well-balanced portfolio.

When checking your asset mix, start by evaluating your investment goals, time frame, and risk tolerance. Ask yourself what you are investing for and the timeframe within which you'll need the money. For instance, are you saving for retirement, or do you need the funds for a down payment on a house in the near future? Your goals and time frame will dictate the level of risk you can take on. Generally, stocks are considered riskier than bonds, and bonds are riskier than cash. If you have a longer time horizon and a higher risk tolerance, you may opt for a higher percentage of stocks in your portfolio.

Once you've assessed your goals and risk tolerance, it's time to determine your target asset mix. This is the ideal mix of stocks, bonds, and cash that aligns with your investment objectives. A common rule of thumb is to have a mix of assets that adds up to 100%. For example, a portfolio with 90% stocks and 10% bonds carries more risk but offers the potential for higher returns, compared to a portfolio with 60% stocks and 40% bonds.

It's also important to understand how different asset classes respond to market movements. Holding a diverse range of assets reduces overall risk and positions your portfolio to weather market volatility. Consider the historical performance of different asset classes and how they have responded to market ups and downs over time. This will help you make informed decisions about your asset allocation.

Additionally, diversification within each asset class is key. For example, when investing in stocks, consider diversifying across market capitalization (small, mid, and large caps), sectors, and geography. This helps to further mitigate risk, as not all caps, sectors, and regions perform equally well at the same time.

Lastly, remember that your asset mix is not static. It requires regular check-ins and rebalancing to ensure it remains aligned with your goals and risk tolerance. Market performance can cause your asset mix to drift from your target allocation. Therefore, it's important to monitor your portfolio periodically and make adjustments to maintain the appropriate risk level for your investment strategy.

By following these steps and considerations, you can effectively check your asset mix and ensure it aligns with your investment goals, time frame, and risk tolerance.

Consider your sector exposure

When testing your investment portfolio, it is important to consider your sector exposure. This is because market exposure, which refers to the amount of funds or percentage of a portfolio invested in a particular type of security, market sector, or industry, is a tool used to measure and balance risk in an investment portfolio.

To determine whether your portfolio needs to undergo broader diversification, you can compare your portfolio's sector allocation to that of a global index like the MSCI World Stock Index or the S&P 500. Your portfolio's sector allocations should not deviate too much from the index's. For example, if the S&P 500 is about 25% tech stocks, an investor allocating 50% to tech stocks would be taking on significant risk.

You can also use tools like Empower, which has an Investment Checkup feature, to analyze your portfolio for concentration risk. This feature allows you to see if you have too much of any one position, which may threaten your portfolio's risk profile.

Although you should diversify across a variety of sectors, you can buffer your portfolio by tilting investments towards sectors that have traditionally been less volatile and performed better in bad markets, such as consumer staples, healthcare, and utilities.

It is recommended that you rebalance your portfolio at least once a year, or even twice a year, as your positions can change quite drastically over time.

Look at liquidity

Liquidity is a crucial factor to consider when testing your investment portfolio. It refers to how efficiently or easily an asset or security can be converted into cash without impacting its market price. When examining liquidity, it's important to understand the difference between liquid and illiquid assets.

Liquid assets are those that can be quickly and easily converted into cash, retaining their basic market value throughout the conversion process. Examples of liquid assets include cash, cash alternatives such as money market accounts, certificates of deposit (CDs), and treasury bills, as well as stocks and bonds. The level of liquidity within these asset classes can vary. For instance, large-cap stocks are known for their high trading volume, tight bid-ask spread, and fast trade options, making them highly liquid.

On the other hand, illiquid assets take longer to convert into cash, and you may lose money if you need to sell them quickly. Examples of illiquid assets include real estate, art, collectibles, jewellery, and equipment. These assets are more challenging to liquidate because finding a buyer can be a time-consuming process, and selling them urgently may result in a loss.

When assessing the liquidity of your investment portfolio, it's essential to consider how quickly you might need to access your investments. For instance, in the event of a bear market, which is sometimes accompanied by recessions and layoffs, you may need to tap into your investments unexpectedly. Therefore, it is recommended to have at least six months' worth of income in liquid assets that can be converted to cash within a short period, ideally within seven days or 24 hours. This ensures financial flexibility and security during uncertain times.

Additionally, when investing in stocks, it's important to evaluate their liquidity by considering factors such as trading volume, bid-ask spread, and the efficiency of the respective market. Stocks with high trading volume are generally more liquid, as there are more buyers and sellers, making it easier to sell without significantly affecting the stock's price. A tighter bid-ask spread also indicates higher liquidity, allowing for a quick sale without a substantial drop in value.

Keep costs to a minimum

Keeping costs to a minimum is an important component of successful investing. Even small increases in cost, when multiplied over a lifetime of investing, can significantly erode a portfolio's value. For example, a $100,000 portfolio that earns a 6% return and incurs 0.25% in expenses will result in a balance of about $530,000 at the end of 30 years. Increasing the expenses to 0.9% sees the ending balance drop to around $438,000.

A portfolio of low-cost index funds should aim for a weighted expense ratio of no more than 0.25%. Actively managed funds should not exceed a ratio of 0.50%. Anything above these levels warrants close scrutiny.

In 2016, the average expense ratio for actively managed funds was 0.82%, according to the Investment Company Institute, down from 1.08% in 1996. A low-cost portfolio should aim for expense ratios of less than 0.25% for passive funds and no more than 0.8% for actively managed funds.

Test how your asset allocation and spending needs affect your portfolio

Testing how your asset allocation and spending needs affect your portfolio is a crucial aspect of investment management. Here are some detailed instructions to help you through the process:

Determine Your Risk Tolerance:

Firstly, it's essential to understand your risk tolerance, which is a key factor in deciding your asset allocation. Ask yourself how comfortable you are with taking risks. Are you willing to tolerate market volatility and potential losses in pursuit of higher returns? Or do you prefer a more conservative approach with stable, lower-risk investments? Your risk tolerance will guide the types of assets you choose and the percentage allocation for each.

Assess Your Investment Goals and Time Horizon:

Consider what you want to achieve with your investments and over what time frame. Are you investing for retirement, saving for a specific goal, or seeking capital growth? Your goals and time horizon will influence your asset allocation. For example, if you're investing for retirement, you may opt for a more conservative approach as you get closer to retirement age, gradually reducing risk by allocating more to bonds and less to stocks.

Calculate Your Required Rate of Return:

Determine the rate of return you need to meet your investment goals. This calculation will depend on factors such as your initial investment amount, desired future value, and the time you have to invest. For example, if you plan to retire in 20 years, calculate the annual rate of return you need to reach your retirement savings goal.

Choose Your Asset Allocation:

Based on your risk tolerance, investment goals, and required rate of return, decide on the mix of assets in your portfolio. Typically, a portfolio includes a combination of stocks, bonds, and cash or cash equivalents. Stocks offer higher potential returns but come with higher risk. Bonds provide more stable, fixed-income returns, while cash provides liquidity and safety. You can further diversify by investing in different types of stocks (e.g., large-cap, mid-cap, small-cap) and exploring other asset classes like real estate investment trusts (REITs) or international securities.

Monitor and Rebalance Your Portfolio:

Your asset allocation should be regularly reviewed and adjusted to ensure it remains aligned with your goals and risk tolerance. Life events, market changes, and economic conditions can all impact your portfolio's performance. Periodically check if your portfolio's sector allocations deviate significantly from relevant indices, and rebalance if necessary to maintain your desired mix of assets.

Stress Test Your Portfolio:

Use stress testing tools to assess how your portfolio would fare under various market scenarios, such as sharp downturns or specific market shocks. This process can help identify potential weaknesses in your asset allocation and prompt adjustments to make your portfolio more resilient.

Remember, there is no one-size-fits-all approach to asset allocation. It's a highly personalized decision that requires ongoing monitoring and adjustments as your life circumstances, the market, and your goals evolve.

Frequently asked questions