The core premise of the modern portfolio strategy is the establishment of the “efficient frontier”. The theory suggests that, when constructed correctly, it is possible for a portfolio to offer a maximum level of return for a given level of risk.
As a result, the potential returns offered by any portfolio is determined by the amount of risk which each investor is prepared to take. We feel that this methodology, which research has shown to yield a healthy balance between risk and return, is the optimal portfolio construction strategy and as such, all of our portfolios follow this structure.
Having established the factors of risk that can be combined to form a suitable portfolio - and a means for measuring its risk - we can now step through the process of building a portfolio.
The following diagram illustrates a framework for the construction of portfolios:
Step 1: Determine the basic equity/fixed income split
Our portfolios are gradually allocated increasing amounts of equity from Portfolio 1 to Portfolio 7.
The greater the proportion of equity in a portfolio, the more risk that portfolio will be exposed to.
Step 2: Determine the international equity dimension
The equity component of the portfolios is split proportionally across the developed world, according to the market capitalisation of each country. This helps ensure a well-diversified portfolio and avoids a bias towards any one particular country.
There is also an allocation to emerging markets within the equity component of the portfolios. Emerging market equities have higher levels of risk than developed market equities and, as a result, the expected returns of these equities are higher.
Step 3: Determine the size and value equity dimension
Factors to consider:
Risk/return: Increasing allocation to small and/or value stocks may increase risk, expected return and tracking error, but may not increase volatility
Sensitivity to tracking error: Increased sensitivity to prolonged periods of underperformance to the market
Our analysis tool gives us access to the longest possible string of returns information, ensuring that we can accurately back-test our models.
When deciding which portfolio is most suitable for your planning needs, it is important that you understand the risk you are taking and the potential for capital loss.
This graph shows what an investment of £100,000 into different risk-rated portfolios would have achieved over the past 25 years.
Determination of risk appetite
Using this layered and structured methodology, we are left with a series of investment portfolios with varying levels of risk.
The final step is to determine the risk profile of the investor. There are two core aspects to determine this. The first is the appetite for risk. We ascertain the level of risk an individual is prepared to accept. This is usually established through a questionnaire, specifically designed to probe the investors' risk profile through carefully selected questions.
The second element, and one that is too often overlooked, is the capacity for risk. While the investor may be prepared to expose their investment to heightened risk, in search of greater returns, they may not be in a position to tolerate significant losses.
This element is usually established through a more in-depth discussion surrounding an individual’s financial position, taking into account the stage within their life cycle. As a result, it is very important that these details are discussed with your financial adviser to ensure that all elements of your risk profile are taken into account when creating your investment portfolio.