The most common error when building a portfolio

One of the most common mistakes when an individual investor build an investment portfolio with an objective other than to simply trade short-term in the financial markets with a few assets, is to keep on adding assets or products that are considered to be more suited at each outlook of financial markets, sector or asset. 

The result of this is an aggregate of financial assets rather than an investment portfolio.

In most cases, this is due to an unawareness of not only what a portfolio is but also that there is a methodology for building an investment portfolio. As a result:

1. The different behaviour of each asset or product in different market situations has not been adequately assessed.
2.  The overall risk of the portfolio is a consequence and not an objective, since the overall risk of a portfolio is not equal to the sum of the individual risks of each of the assets that make up the portfolio.
3.  Diversification is also a consequence or has been carried out intuitively.

Faced with this bottom-up erroneous process of portfolio construction, there is an orderly decision-making process methodology  that allows the construction of a portfolio based on its overall level of risk with an improved risk-return profile.

Methodology: how to build an investment portfolio step-by-step

This methodology starts by defining the overall risk level of the portfolio based on the investor profile, mainly: investment time horizon, risk aversion/appetite and liquidity requirements, and consists of the following three steps:

1. Asset Allocation 

This involves defining the global structure of the portfolio based on the main asset classes according to the level of defined risk. In turn, this first step is broken down into two stages:

1. The first stage is to define the composition of the portfolio with the main asset classes such as Fixed Income and Equities. Also, for example, Real Estate Assets, Commodities or even, if the level of risk allows it, Cryptocurrencies.
2. The second stage is to establish the different geographical areas, industries or sectors, in the case of equities, and the type of issuer, duration and credit quality, in the case of fixed income, with which the main asset classes defined previously are to be represented.

In this first step if we want pure passive management we have the option of the market portfolio, which consists of buying all the assets in the world (shares, corporate and government bonds) in the proportion they make up the market at that given time.

2. Security Selection

The second step is the “Security Selection” and consists of assigning specific assets to each of the asset classes defined previously. 

In this step we will decide which style of asset management we want for our entire portfolio or for each or several of the asset classes that make up the portfolio. We can choose different asset management styles depending on the characteristics of each asset class and also with products that combine some asset classes, opening up an infinite range of possibilities:

1. Portfolios consisting of individual assets listed in the financial markets with discretionary management by a professional or self-managed.
2.  Mutual Funds or ETFs (Exchange-Traded Funds (ETFs) of active management in their different styles: Among them Value Investing, Absolute Return…
3. Mutual Funds or ETFs of the different versions of passive management such as indexed, Enhanced Index, Factor Investing, Smart Beta…
4. Mutual funds or direct investment in financial assets not listed on the exchange. These are investments in companies at different stages of business development in the form of capital or debt. For example, a portfolio made up of Start-ups in their different stages or in more consolidated companies, either through funds (Venture Capital or Private Equity) or directly.

3. Latest risk considerations

As a third step at the end of the process, it would be desirable:

1. To check that the overall risk of the portfolio we have built match to what was defined before starting the process of portfolio building, and modify the portfolio should it be necessary. This is especially the case if you have decided to put too much weight on a particular sector or industry or even a particular asset, or you have used several mixed products where there may be overlapping assets between them.
2. Improve the overall risk-return profile of the portfolio by measuring the portfolio’s assets correlations. To do this we will use advanced portfolio optimisation tools that will guide us in this work.
3. Whenever we incorporate future expectations at the individual asset level, take the Risk Investing test, which will soon be available in investment tools on our website and which we will discuss in detail in another publication. Risk Investing shows if our expected returns balance out the market risk that we will probably assume.

Conclusion

Building an investment portfolio is not an intuitive process based on the expectations or opportunities that we believe financial markets can offer us.

Building a portfolio is a methodological decision-making process that guarantees your portfolio are within the level of risk that you want and can take. It also ensures that the portfolio has been consciously and appropriately diversified and built to be in an environment of overall portfolio’ risk-return maximisation.

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