How does one construct the optimum portfolio? There are many approaches and differing opinions on the best way to manage your portfolio. The conclusion comes down to which style or philosophy leaves you feeling the most comfortable while you fully understand the cost, risks and potential performance of that strategy.
For this discussion, we are omitting trading and momentum investment styles, where the concept of risk is largely ignored.
In the 1930s, Benjamin Graham described the role of valuation in investing in his book “Security Analysis.” Graham offered a simple method of how an investor might vary his portfolio holdings of stocks and bonds (or cash) between a range of 25 percent to 75 percent. When stocks are expensive on a valuation basis, their allocated range should be closer to 25 percent, with the bond component nearer 75 percent. When stocks were valued cheaply, the portfolio would hold a 75-percent stock component with the bond or cash allocation dropping to 25 percent.
Another style that came into vogue in the 1950s was based on the work of Nobel Prize-winning economist Harry Markowitz. His method centered on a mathematical framework for investing called modern portfolio theory, or MPT.
MPT advocated a diversified portfolio that seeks the highest return for a given level of risk. With diversification as its central theme, the theory’s mathematics showed that, as different assets were added to a portfolio—assets whose returns were not correlated to one another—an investor could increase his overall return and lower his risk. Risk in MPT is defined as the standard deviation of the portfolio, which measures the variability of returns around the mean return of the portfolio.
Another style of portfolio management is asset allocation, which begins with an index like the S&P 500 and the weightings of the 10 industry groups that comprise the index: technology, 18 percent; financials, 16 percent; health care, 12 percent; consumer discretionary, 12 percent; energy, 11 percent; consumer staples, 11 percent; industrials, 10 percent; materials, 4 percent; utilities, 3 percent; and telecom, 3 percent.
The portfolio is then structured by adjusting weightings based on where the manager sees the best opportunities. For example, the manager believes oil stocks are particularly attractive, so he buys oil stocks to overweight the energy holdings. At the same time, he might drop technology stocks to a 13-percent weight.
Following the success of Yale’s endowment in the 1990s, portfolio managers expanded their asset classes to include real estate, private equity, hedge funds, commodities and currencies. The “quants,” or quantitative managers, have taken the original principles of MPT and enhanced the strategy by adding asset classes, adjusting asset allocations and adding leverage in running their “risk parity” strategies.
The quants argue they can manage large sums of money across broadly diversified investments and achieve respectable returns, at a lower cost, with less volatility.
As ill-advised as it might be to argue with a PhD in finance, value investors would contest that when one identifies an excellent opportunity at an attractive valuation, a significant portfolio commitment should be made. To them, managing a concentrated portfolio of undervalued stocks is not any riskier than an overly diversified MPT portfolio.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.