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There are many ways in which a financial adviser can consider constructing an investment portfolio. It is by no means my intention to recommend preferred strategies, nor to comprehensively describe any one or more concepts in any great detail.

Instead, I seek here to outline and briefly discuss three fundamental strategies and concepts which can be easily and very profitably applied by portfolio planners.

All three strategies are based on clear, concise and readily available information, the ongoing use of which can be justified not only on theoretical and mathematical grounds but also (and probably most important) on the basis of logic and common sense.

The three concepts and strategies at the core of this and my next article are:

l Diversification and correlation.

l Projecting investment returns.

l Measurement and use of volatility.

It is widely believed among many investment advisers and their clients that in order to realistically hope for a higher level of finan- cial reward from a portfolio, it is necessary to accept a higher level of risk.

A typical example of this belief refers to a comparison of the historical performance of cash (money on deposit) and equities. Money on deposit has over the medium to long term produced low levels of return but has been the least volatile among all the major asset classes while the equity market has generated the highest asset class returns and also the highest level of volatility.

But this perceived relationship between risk and return, although usually true of individual asset classes and sectors, must be called into question when planning and considering a well-structured, diversified portfolio.

The fundamental aim of this article is to outline and discuss ways in which an investment portfolio might be constructed to produce lower levels of overall risk with maintained levels of investment returns or improved levels of investment returns with maintained levels of risk. In fact, I suggest it is by no means beyond the bounds of possibility that higher levels of return can be achieved with lower levels of risk.

Whichever of these aims might be the most attractive to individual clients, there is no doubt that the strategies and methodologies I will be suggesting must be of interest to all investors.

In previous discussions, I have noted that diversification might not reduce portfolio risk – or not by as much as might be anticipated – if the investments held within the portfolio might be expected to rise and fall in value in a similar way to each other.

To ensure reduction in risk by diversification within a portfolio, it is essential to verify that the spread of investments are lowly correlated with each other, meaning that the price behaviour of one of the constituent parts of the portfolio has little or no bearing or influence on the price behaviour of one or more of the other constituent parts. In other words, with low correlation relationships, the short-term values of each of the asset classes or sectors held within the portfolio will be moving independently of each other.

If we briefly consider a portfolio made up of entirely non-correlated holdings, it can be seen that the total investment returns will be the average of the constituent parts but the risk profile of the portfolio as a whole will be significantly reduced as, when parts of the portfolio are performing well, others will be performing badly. If, instead, the portfolio had been wholly invested in just one asset class, the returns might be no better than our widely-diversified and low-correlated portfolio but the residual risk would in all probability be higher.

This is a fundamental result of portfolios which give due consideration to correlation relationships between different asset classes and sectors. An investor can hope and probably expect to achieve a higher rate of investment return for no greater level of portfolio risk or a lower level of portfolio risk with maintained levels of investment return.

In short, the investor might well be able to have his cake and eat it.

I strongly recommend investment advisers to obtain up-to-date correlation grids, the primary one showing inter-correlation between the major asset classes (cash, fixed interest, index-linked securities, property, UK equities and overseas equities), with subsidiary grids showing inter-correlation between sectors within those asset classes (see table opposite).

In summary, the planning of a low correlation mix of asset classes and sectors could be a convenient first step in portfolio construc- tion as it aims to control or reduce risk profile.

Controlling or reducing risk using correlation is one of the two main aspects of portfolio construction. Maintaining or increasing investment returns is the other. It is, as outlined above, quite a simple task to reduce portfolio risk by using correlation factors but this reduction in risk might be achieved at the expense of a reduction in investment returns if the adviser is tempted towards more mundane assets such as cash and fixed-interest gilts.

Identifying likely returns from different asset classes and sectors is not simply (if, indeed, it is at all) a strategy of assuming that historical returns are likely to continue in to the future. There are frequently fundamental changes in investment markets, for example, significant falls in interest rates, which make this approach inaccurate.

Other methods of assessing likely future investment returns can profitably be identified. For the purposes of this overview, the follow- ing brief summary should usefully suffice (see table below). The benefit of ascertaining and using justifiable investment growth rates for the differ- ent asset classes is to enable realistic projections to be made which are specific to each particular portfolio.

This is surely preferable to simply offering some bland uni-portfolio assumed growth rate (for example, 5 per cent, 7 per cent or 9 per cent as has previously been used for pension fund projections) which does not even attempt to recognise the near certainty that different asset classes will produce very different levels of investment returns.

Most portfolios will not, of course, invest in just one asset class and so a sample consolidated projection rate can be calculated and presented to the client.

In my next article, I will conclude my discussion of investment portfolio by looking at the measurement and use of volatility.


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