Investing’s enigmas might be demystified best by adopting the mindset of a child and asking the most basic questions.  According to Darron West of Cape Town based asset management company, Foord, one of these apparent enigmas is portfolio construction, or how to build a portfolio of investments, and why this should be done. 

Having a portfolio is vital, as is the construction of that portfolio.  But why?

“For the purpose of illustration, extreme examples can be used.  Presume for a moment that your entire worldly wealth is invested in a single asset,” says West.  “You know and understand that asset, and you have carefully appraised its value.  Notwithstanding your best efforts, the market’s vagaries prevail and the value of your investment halves!”

“Now, presume that your entire worldly wealth is invested equally between two assets.  However, these assets tend to exhibit negatively correlated behavior i.e. when one goes up, the other tends to go down.  Again, your knowledge and understanding cannot be faulted and again, the market’s whims halve the value of the first asset, but double the value of the second.  Your portfolio’s value, instead of halving, increases by 25%.”

“As more negatively correlated or uncorrelated assets are added to the portfolio, so the chances of value destruction decrease by minimizing the negative effects of any single asset.  This is the benefit of diversification,” explains West.

“Diversification reduces the effects of being wrong (and to err, after all, is human).  It may be the only “free lunch” that the market has to offer.”

West advises that all investors should use diversification as often as possible, but not as much as possible.  “Too much diversification, or incorrect attempts at diversification using assets with highly positively correlated returns, may result in “diworsification” (a fabricated word implying “made worse, not better, by diversification”), which has the potential effect of reducing expected returns, or, at best, earning only the average.”

Portfolio construction makes essential use of diversification.  But why?

“Diversification reduces risk.  It should be made clear that risk should not be equated with price volatility,” says West, “but rather, risk should be defined as the risk of permanent loss arising from the misguided act of buying an asset when it is too expensive and selling it when it is too cheap.  Stated differently, risk is the chance of not achieving one’s required returns.”

“Risk has to do with certainty and uncertainty.  The greater the uncertainty inherent in achieving a return from an asset, the greater the expected return should be.  Conversely, the lower the uncertainty in producing a return, the lower that return is.”

According to West, this is where the distinction between volatility and uncertainty should be made clear.  “An investor may have greater certainty about the return to be earned from an investment over a period, but the path to earn that return may be volatile.  It is for precisely this reason that investors in quality equities or equity funds should be advised to hold such investments for longer periods (in excess of five years) for the requisite returns to materialize.  A cash deposit, by contrast, earns a low, but certain return over a known (and typically short) period.”

Portfolio construction uses diversification to reduce risk.  But why?

“The cold and logical answer to this question,” says West, “revolves around rational choice:  given two assets with the same return but differing risk, the investor would select the asset offered at the lower risk.  It stands to reason that you would choose to minimize risk for a given level of return.”

“Furthermore, notwithstanding your circumstances and your cogent perception of your tolerance for risk, it is highly likely that you are, in fact, more risk averse than you think.  This attribute has been demonstrated time and again by investors in weak markets.”

West advises that it is our very humanity that makes us like this.  We feel the pain of losses far more acutely and deeply than we feel the pleasure of gains. 

“Also, many investors seem unable to think in a holistic portfolio context – they tend to compartmentalize their investments, making decisions based on the performance of portions of the portfolio, rather than the portfolio as a whole, often to their detriment.”

Our child-like questioning must now change to “How?”

“For the average investor, portfolio construction can be fraught with difficulty,” explains West.  “We often forget that many of us remain highly exposed to property through the homes in which we live.  Furthermore, we all have differing investment horizons and cash flow requirements.”

“Notwithstanding these differences, an excellent default option is the selection of a flexible fund managed by a reputable fund manager with a long term track record of consistently good performance.  One size might not fit all, but such a fund would be an astute inclusion as the core of most portfolios.”

“A flexible fund is one where a suitably skilled fund manager invests in a portfolio diversified across asset classes in an effort to deliver appreciable real returns with a minimum of risk.  In selecting such a fund manager, investors should be convinced as to that manager’s specific ability in performing asset allocation.”

“In an investment environment fraught with complexity, the beauty of child-like questioning is in the simplicity of the answers.  Understanding the construction and role of a portfolio is critical for investors.  So often, wisdom comes from the mouths of babes,” concludes West.