Investing Based on Portfolio Construction Theory

portfolio construction theory
March 30th, 2020 0 Comments

In one sense, all investors are the same in that each individual with an investment portfolio wants to see the highest returns possible for the money they invest. While this is universal, just about everything else that determines the best investment strategy one should take makes the endeavor an individual one. We’ve talked about portfolio construction before, but this time we’ll dive deeper into the theory behind it.

There are plenty of economists that have spent their careers trying to work out the complexities of the free market, how investments play a role, and how investors can benefit as much as possible. The calculations they perform and the conclusions they reach are often pretty advanced. It isn’t generally stuff that the layperson can easily understand and put into practice.

This is why there are so many professionals in the financial industry that are dedicated to offering expert guidance to investors in need. It’s wise to take advantage of this kind of help if you ever need it  — there’s no real substitute for the guidance of an experienced advisor.

That said, it isn’t advisable to keep yourself completely in the dark. Attaining even a basic understanding of how investment portfolios work will make your life considerably easier. It will also put you in a better position to make intelligent financial decisions.


Modern Portfolio Theory (MPT)

Nearly all guidance that financial advisors offer regarding the construction of an investment portfolio contains some element of MPT. It is a theory that was first developed by economist Harry Markowitz in his paper, Portfolio Selection. Markowitz later earned a Nobel Prize for his work creating the MPT.

One of the important take-aways from this paper is the concept of mean-variance optimization. In short, weighing the risk of an investment against potential reward. This simple concept forms a central part of MPT and helps inform smart investment choices. The other central component is the assumption that investors want as little risk as possible.

To define it in a nutshell, MPT is a theory for how investors can maximize the level of expected return for a given level of market risk. It takes into account the risk-return tradeoff and highlights ways in which investors can get the most out of the level of risk that they are willing to assume.


Risk in Your Portfolio

You’d be hard-pressed to find any literature or advice on portfolio construction that didn’t mention risk. The fact is, it’s a necessary part of investing, and without it, there would be no potential for reward.

Given that risk is a necessary part of investing, the ideal investment portfolio will offer you the highest potential reward for the associated risk. Markowitz referred to these optimized portfolios as the “efficient frontier” because of where they lie on a graph called the Markowitz Bullet.

But how much risk are you willing to introduce into your investment portfolio? The answer to this question depends on several things, one of which is your personal risk tolerance. If having a portfolio with a higher level of risk will keep you up at night, it’s probably not worth it!

Other important factors are the financial goals you hope to achieve and the time you have to achieve them. The stock market is volatile but tends to follow upward trends in the long run. This is useful information when planning your investments.

Those with shorter time horizons should generally take on a lower level of risk in their investments. This is because an unexpected downturn in the market could leave the investor without enough time to recoup their losses. The nearer you get to retirement, for example, the less risky you want your investments to be.

Investors that have more time to reach their financial goals, on the other hand, can usually handle greater levels of risk. This is because they’ve got the time to weather short-term losses in favor of larger overall gains in the long-term.

Good portfolio construction theory dictates that the level of risk in a portfolio should change as time horizons grow shorter in order to remain optimal.


Diversity and The Mutual Fund Theorem

Along with risk, we’ve also spoken before on the importance of maintaining a diversified portfolio. It’s actually one of the most crucial things you can do for your portfolio.

Why is diversification a good thing? Basically, because it minimizes risk. You can think of it like putting all of your eggs in multiple baskets. You aren’t at risk of losing all of your eggs if you drop one.

What does it look like? A portfolio can achieve diversity in a number of ways. One of the most obvious ways is to invest in multiple types of assets (stocks, bonds, cash and equivalents, etc.). You can also invest in different industries or even in different geographical locations. Investing in foreign markets is an often overlooked way to diversify a portfolio.

Fortunately, there’s an investment category that has diversity built into it — mutual funds. Mutual funds are portfolios of investments that are operated by professional money managers. They contain various types of investments.

By investing in a mutual fund, the investor becomes a shareholder of a portion of the entire portfolio. This means that the investor will see gains or losses representative of the performance of the portfolio as a whole.

There is a wide range of types of mutual funds out there. Some are focused more heavily on a specific industry or market-cap size. Others are even based on ethical investing principles.

The point is, they offer some easily accessible diversity without requiring the investor to seek out a bunch of different options.

The mutual fund theorem was developed by a man named James Toben, who worked alongside Harry Markowitz. The theorem takes cues from the MPT in describing how to build a portfolio of exclusively mutual funds. The theorem draws on the importance of having a diversified portfolio in the interest of minimizing risk.


Selecting Mutual Funds

Mutual funds are powerful tools in an investment portfolio, and there are some key criteria one should look at when decided which funds to invest in. Not all mutual funds are created equal, and determining the quality of prospective investments takes careful consideration.

It’s important to look at what types of investments make up the fund as well as the investment style of the fund. You should also consider the expenses associated with the fund, the risk-return profile, and any analysis reports that are available to you.

Not sure you’re making the right decision? That’s normal. Sometimes it takes the practiced eye of an experienced professional to guide you in the right direction. Choosing the right mutual funds to invest in is certainly something that a skilled financial advisor can help you with.


Portfolio Construction, Simplified

If you were to break portfolio construction down into its two most basic steps, they would be asset allocation and investment selection. This is looking at the process in broad strokes, but it makes it easier to conceptualize the big picture.

Asset Allocation

In this step, the investor decides which percentage of their total assets they’d like to invest in different asset classes. There are a ton of factors that account for the right decision: investor age, time horizons, financial goals, and risk tolerance are the main ones.

This isn’t something you can figure out once and then never revisit. Instead, it’s something that should change alongside your changing financial circumstances. Different asset allocations mean different levels of risk and reward.


Investment Selection

After you’ve come up with the ideal allocation of assets in your investment portfolio, you’ll have to choose the specific investments in each of the asset classes. These choices are additional opportunities to enhance the diversity of your portfolio and increase or decrease the level of risk and potential reward.

This is another area in which it is often helpful to have a professional financial advisor by your side offering you guidance.


In Closing

Understanding the theory behind portfolio construction may not be the easiest thing in the world, but there are professionals who make a living doing just that. In the interest of crafting the perfect financial portfolio for your situation, consider hiring an experienced professional. There’s little more to inspire confidence than knowing an expert in the field is helping you make the best decisions possible.


We Can Help

There are few things that affect as many areas of your life as your wealth. Treat it with the attention it deserves and it will repay the favor. Whether you’re thinking about retirement or estate planning or want to use your wealth to provide for younger generations, proper wealth and portfolio management is what will make it happen.

At Saddock Wealth, we bring years of wealth management experience to the table and can guide you toward financial prosperity. Make sure your wealth is in the right hands and ready to grow in 2020. Schedule a meeting here, and we’ll discuss your best options.



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Investing Based on Portfolio Construction Theory
Any way you allocate your assets in your investment portfolio, there will be a level of risk. Today we break down the modern portfolio construction theory.
Portfolio Construction and Diversification