The Process Behind Building A Resilient Portfolio For You
Have you ever worked towards a goal when circumstances didn’t work in your favor along the way, taking you further away from reaching your goal? I think we’ve all been there, and the case can apply when investing.
Investing is hard to begin with, and we think it’s going to get harder. Prices from fuel to food are increasing, which has reduced purchasing power and wealth. To counteract this, Central Banks are raising interest rates to fight inflation, but with it comes the risk of a recession. All of this creates uncertainty, and volatility in markets as investors around the world express different views on what to buy, sell or hold in their investment portfolios.
This means investing is going to get harder, and if your investment portfolio isn’t positioned appropriately you may be at risk steering away from reaching your investment goals. That’s why Portfolio Construction is important to alleviate this risk and make sure your portfolio is well-positioned.
Portfolio Construction is essentially like cooking a meal. From choosing a dish you’d like to make, to choosing the right ingredients and tasting it before it's served to ensure it’s to your liking. Similarly, Portfolio Construction is a process of understanding how different asset classes and instruments perform, how they impact and correlate with each other, what their risk profiles are, and importantly how the decision making process aligns with the portfolio’s objectives.
Side note: It is common for many of us just to buy a few high-performing stocks or companies most familiar to us. However, by not properly thinking about portfolio construction and how these stocks relate to each other can expose a portfolio to unforeseen risks. For example, you own a company that produces toothpaste (Stock A) and a company that produces rice (Stock B). At face value, they may look like very different companies. But if, for example, natural gas prices rise then both companies will find it more expensive to produce their respective products. This is because menthol is a byproduct of natural gas, which is needed in your toothpaste. Similarly, rice paddies require fertilizer to grow, which is also a byproduct of natural gas. So, while our portfolio appears diversified at face value, it may not be resilient when looking deeper.
Portfolio Construction is taken seriously by the biggest and most sophisticated investors - like Pension Funds, Central Banks and Sovereign Wealth Funds globally. We believe Portfolio Construction allows for a more disciplined and holistic approach to building better portfolios - and therefore, better chances to meet or exceed your investment objectives.
Let’s outline the steps of building an expertly-managed investment portfolio.
1. Goal Setting
Begin at the end - what’s your goal? Whether it be to save to send your children to university or to indulge in that trip to Bali, your goal defines how much you’ll need, when you’ll need it, and how much risk is appropriate to take when shaping a portfolio.
Benchmarking allows investors to measure performance against a point of reference throughout the investment process. If we were to borrow our cooking analogy, it’s like having a frame of reference when comparing between a good or mediocre beef rendang.
For example, when comparing which government bonds to buy for your portfolio, we would analyze the yield it would generate and the time to maturity, among other things, and compare them against similar types of bonds, or an index of bonds with similar time to maturity as a benchmark.
When the time comes to complete the portfolio, having a benchmark helps evaluate performance and risk. Let’s take a portfolio of stocks. We could benchmark this portfolio against the Jakarta Composite Index (JCI), where we can not only see how our selection of stocks compare against the benchmark from a returns perspective, but also a risk perspective.
Benchmarking also helps us evaluate if the risk-adjusted returns are good enough to achieve your goals and measure if you’re on track to meet your investment goals.
Budgeting focuses on ensuring an efficient portfolio so investors can maximize value. This step can get quite technical as it encourages us to think about the costs like management fees, brokerage fees and taxes, but also budgeting for risk.
Let’s take stocks and bonds. Budgeting helps us answer how often we want to trade the stocks and bonds in our portfolio, or whether we want to mimic the index. These considerations vary by investor type, market, and geography. In Indonesia, we think having an active investment philosophy is the best way to achieve better risk-adjusted returns in the long run. Read our article on Active vs. Passive investing here.
This should be the easiest part of the process. Having said that, make sure we stick our sights on the goal, and research investments added to or removed from the portfolio thoroughly to understand how it impacts the performance and behavior of your portfolio.
With stocks, it means assessing sectors that are attractive, and finding the best companies to buy. With bonds, it means looking at various types of fixed income securities and finding the best opportunities to match our intended holding period and return profile.
5. Risk Management
While the definition of risk in the context of investing is the probability of losing
money, risk isn’t inherently bad. Returns can be unpredictable, but risk is manageable.
While the concept of risk can get technical, we can use several metrics to assess a portfolio’s exposure to risk, such as Standard Deviation, Value-at-Risk, or Maximum Drawdown.
Side note: Standard Deviation is a common way to measure portfolio risk and volatility, using historical data to measure how often and far the data points differ from the mean. Value-at-Risk, meanwhile, measures the extent of possible losses in a portfolio over a period of time. Lastly, Maximum Drawdown measures how much a portfolio can lose from peak to trough over a time period. These are some of the many metrics we can assess risk in a portfolio.
But good risk management stretches beyond measuring portfolio risk. It looks granularly into the types of stocks and bonds that enter the portfolio, how it behaves in various scenarios - such as when interest rates rise or when an economy enters a recession.
With the right understanding of risk, and how it affects investment portfolios, you are able to improve the likelihood of achieving your goals.
Once you have your portfolio built out and invested, it’s as important to monitor the portfolio regularly - typically monthly or quarterly, to assess whether the investment strategy requires any tweaks or adjustments to achieve your goals.
- reviewing the performance of the portfolio against our set benchmark,
- assessing where the returns are coming from,
- monitoring the consistency of performance,
- changes to the portfolio such as stocks and bonds bought or sold within the period,
- and shifts in asset allocation to reflect changing market conditions.
We think everyone should be able to build portfolios to achieve their goals. Soon with Simpan, you’ll be able to build expertly-managed portfolios according to your goals, and monitor your portfolio at every step of the way. We cannot wait to welcome you on our platform soon. Stay tuned and join our whitelist in the meantime :)
The author is a co-founder of Simpan. Nicholas was previously at BlackRock, a global investment manager, across its New York, Hong Kong, and Singapore offices. In his last role at BlackRock, Nicholas was dual hatting-between BlackRock’s insurance (FIG) and official institutions (OIG) practice, where he worked with large institutions like central banks, sovereign wealth funds, insurers, pension funds, and endowments. Nicholas earned a Bachelor’s Degree from the Pennsylvania State University.