A guide to Portfolio Investing

This is your overview of how to set up your investment strategy and allocation plan: this is not easy and is where most investors stumble. A wrongly built structure will collapse at the first market shock. Let us go through how you can build a strong foundation and a robust investment methodology to protect your portfolio.

The starting point for choosing your portfolio strategy is to decide which asset classes are low or high risk. Once this is done. you will conduct an asset allocation process to decide the proportion and type of assets you require to achieve your goals. Let us look at risk and its relation to different assets in more detail.

What are the risks we face as investors?

Risk can be caused by volatility, inflation, economic conditions, central bank actions, industry, company and political events, liquidity constraints, leverage, pandemics, climate change, concentrated portfolios, and defaults.

We can segregate investments into two forms. Liquid and alternative investments.

a) Liquid investments: These can be priced daily and are more transparent. These are cash, bonds, stocks, ETFs, mutual funds, derivatives, and commodities.

Low risk assets: Cash, investment grade bonds, capital protected structured products

High risk assets: Equity, Commodities, High yield bonds, structured products like reverse convertibles, and accumulators

b) Alternative Assets: These are more complex and less liquid assets and therefore have been viewed as higher risk. In terms of pure alternative portfolios, the relative risks of the different assets are segregated as:

Lower risk: Income generating real estate and hedge fund non-market correlated portfolios.

High risk: Private equity, venture capital, pre-IPOs, private debt, and hedge fund growth portfolios.

Risk can be further reduced by diversification, hedging and less leverage.

How do investors perceive risk?

Investor perceptions of risk are a function of their past experiences with particular asset classes and their sense of comfort with these. Income generating real estate has been very popular for this reason. The perception of risk and reward also fluctuates over the short and long term. Assets being priced daily such as stocks therefore generate more sense of insecurity compared to a building which is valued infrequently.

If the markets become more volatile the fear of the investor increases. The potential of drawdowns and meltdowns increases the sense of risk for all the asset classes except treasuries and cash.

The perception of risk is also a function of the perceived risk reward of the asset. If there is a belief that you have purchased the asset at a discount to fair value, there may be less risk related pressure on the asset.

How do we determine risk reward ratios for the different asset classes?

Building a Heat Map:

This exercise should be conducted to allow the macro market conditions to be factored into your asset allocation exercise. Creating a heat map at an asset class, geographic and industry level will help bring clarity to the risk reward analysis.

Determining the Asset Allocation:

The best way is to review each asset class and work out the risk and reward you anticipate. The drawdown risks and target return long term are noted. The framework can be used to figure out the weightings of the different asset classes and which assets you are comfortable to invest in.

You can evaluate your income and capital gain requirements and work out what proportion of assets will get you to your goals and what sort of overall portfolio risks you will be taking.

The impact of leverage can also be ascertained at an asset and portfolio level.

Stress testing your assumptions should allow you to know the risk reward of the portfolio you have designed.

Another aspect of this plan is to create a core portfolio and treat it separate from your riskier growth assets. This will allow you to determine the amount you can invest in growth and its impact on the overall portfolio.

Developing the portfolio strategy:

Once we have come to our target allocations, we have two main ways to invest:

1) Through a diversified vehicle with a specialist asset manager. These are ETFs, mutual and alternative asset funds, managed accounts, and certificate programs.

2) Through direct investments in equity, bonds, pre-IPOs, Venture and PE deals. For this the investor needs to have the expertise or assign an advisor with the skills to select securities and monitor the portfolio.

3) Through a combination of the two.

Monitoring your Portfolio:

Monitoring your portfolio is a repeat of the above exercise, starting from the heat map, asset allocation and carrying on to each security in your portfolio.

This exercise helps you assess risks and frame your response to the market conditions. There will be opportunities and threats for you to evaluate.

If a garden is not tended, it gets invaded by weeds and grows wild. Constant clearing and pruning is required to keep the shape of the portfolio in line with your goals.

Examples of risks facing portfolios are:

Concentrated positions, exposure to leverage, lack of a robust core portfolio, over-exposure to high-risk assets, chasing returns, complex assets, running active trading strategies, poor downside controls, and having an advisor who doesn't monitor your portfolio adequately.

In summary, the asset allocation process helps you frame your risk and return objectives and build a strong foundation for your portfolio. It makes you capable of taking advantage of and weathering market downturns. It also helps you define your investment strategy and style. Having the right support to guide your through the whole allocation and monitoring process of your portfolio is key to achieving a great result.

Sandip Aggarwal

Founder & CEO