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Foundations of portfolio construction

I am considering having you manage an investment portfolio and am intrested to know more about your investment process, how you constructed a portfolio and how you decide on the optimum asset allocation. I would also like to know what assumptions you use for the various asset classes and how these impact on the expected returns.

Each investor’s situation is different so the investment process always addresses certain factors such as the reasons for the investment, the time horizon and the degree of risk the investor can comfortably tolerate.

Setting long-term investment objectives
Taking into account the long-term nature of successful investing, we set objectives for your portfolio appropriate for your investment time horizon and attitude towards risk.

Planning your asset allocation
Because it is so important, asset allocation is the first investment decision. During this process, we decide how much of your portfolio will be invested in each of the different asset classes, including stocks, bonds and short-term investments, both domestic and foreign.

Selecting your invesment approach
With an asset allocation in place, we select the investment vehicles that you will use to implement your strategy. This is guided by two key investment principles – the importance of diversification and the value of remaining invested.

Building your portfolio
Building on the first four steps, we construct a portfolio suited to your needs, goals, investment time horizon and risk attitude. The building blocks for the portfolio are investment funds – an excellent way to implement a diversified portfolio so as to maximise the probability of achieving your goals.

To assess whether your port- folio has a good chance of enabling you to achieve your goals, we use a modelling tool which allows us to input assumptions about various factors which will have a bearing on your returns.

We use as our starting point the element of risk-free investment, about which future returns can be known. To derive assumptions about equity-based investments, we use a concept called the equity market risk premium.

A basic principle of finance is that riskier investments should offer higher potential returns. Equity investments are riskier than bonds and, hence, have a higher expected return. However, the actual return could be less, even over very long time periods.

The most liquid asset is cash, which can be held on deposit with negligible risk. Interest rates generally increase to tighten the supply of money in periods when inflationary pressures are perceived to be rising. Taking the example of the past decade, during which the central banks have controlled interest rates, cash appears to provide a return of about 1.4 times inflation.

Fixed rates
The rewards available from a risk-free investment are a known quantity, both in real and nominal terms. Nominal risk-free returns are provided by conventional gilt-edged securities and real risk-free returns by index-linked gilts.

Although returns vary with the length of time to maturity, this is a forward-looking measure which provides a suitable starting point for assumptions about future investment returns.

Conventional gilt yields currently lie between 4.5 and 5 per cent. Clearly, no single assumption can reflect the spread of returns which might be achieved. However, we suggest that 4.5 per cent provides a workable assumption for the nominal return on a risk-free investment.

Index-linked gilt yields lie between 1.5 and 2 per cent. This range represents a real return over and above inflation. We believe that structural issues with long-term pension liabilities are distorting the picture and depressing yields. Hence, we believe 2 per cent to be a realistic expectation of real returns.

The retail prices index and consumer prices index are the two primary measures of UK inflation. Annual figures to March 2005 show the CPI at 1.6 per cent and RPI (including mortgage interest payments) at 3.2 per cent. Much of the difference between these measures is explained by the exclusion of most hou- sing costs from the CPI calculations. For our purposes, we believe a mid-range figure of 2.5 per cent provides a good working assumption.

Here, we must rely on our expectation that equities will outperform gilts and bonds. This framework supposes that a reasonable assumption for equity returns will be the sum of returns to the risk-free investment element and the equity market risk premium.

A report produced by Price Waterhouse Coopers in June 2003, for the benefit of the FSA, reviews the evidence of several different research methods for arriving at an equity market risk premium. These include canvassing the opinions of investment analysts, stochastic modelling and statistical analysis.

Based on this variety and range of data, we adopt an assumption of 3 per cent.

We have found that the best results are achieved by carefully constructing an investment plan and following that plan consistently over time. A well-crafted plan allows us to agree on specific investment objectives and the strategies by which to attain those goals.

Summary of growth assumptions
Inflation – 2.5%

Cash – 1%

Fixed-interest investments – 2%

Equity investments – 5%

All stated returns for cash, fixed interest and equities are real


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