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Investment portfolio construction made easy

By Clive Preston, Business Development Manager, Glacier by Sanlam

Investors today are confronted with a vast number of investment options and funds to choose from, when constructing an investment portfolio.  Coupled with the wide choice of available funds, investors’ emotions can also get in the way of making an appropriate investment selection.  By following a structured approach, investors can simplify the fund selection process and avoid emotional decision-making:

Step 1:  Determine your risk profile

Investors generally fall into one of five risk profiles – conservative, cautious, moderate, moderately aggressive or aggressive – according to how much equity exposure they’re willing to take on.  An investor’s level of satisfaction with his investment is closely linked to whether it’s in line with his risk profile.  Higher risk generally means higher returns, so an aggressive investor probably won’t be satisfied with the returns from a conservative investment portfolio.  It’s important to consider not only how much risk you’re willing to take, but also how much risk you can afford to take.  Investors typically fear losses more than they anticipate gains.  It’s therefore necessary to be comfortable with your portfolio’s level of equity exposure.

Investors can, however, generally take on more risk if they’re investing over the long term as the impact of the volatility will be smoothed out over the term of the investment.

Step 2:  Strategic asset allocation

This step involves allocating a percentage of the investment amount to each of the main asset classes:  cash, bonds, equity, property and offshore assets.  The allocation depends on one’s risk profile.  Therefore a conservative investor will have less exposure to growth assets such as equities than a more aggressive investor.  All investors, regardless of their risk profile, should have at least some exposure to all of the asset classes.  Investors who stick to a diversified portfolio tend to do better over the long term.

Step 3:  Tactical asset allocation

Once the strategic asset allocation process is done, investors can then increase or decrease their exposure within the different ranges of each asset class, once again according to their risk profile.

Investors can also select asset allocation funds – in this case the asset managers will make the decision on whether to increase or decrease exposure within a particular asset class.  Investors would do well to select a few managers with different investment styles, as at any given time some will outperform the market and others will underperform.

Step 4:  Fund selection

Only now is the investor ready to make a fund selection.  International research shows that strategic asset allocation accounts for around 90% of the portfolio’s long-term return.  Based on this research it’s often found that the investor’s decision-making process is skewed towards asset allocation rather than  fund selection.  However, fund selection remains an important determinant of the overall success of the portfolio and a qualified financial intermediary will be able to assist investors to identify appropriate funds, suited to their risk profile.

Step 5:  Constructing the portfolio

Once the actual portfolio has been constructed, it can be tested against the investor’s risk profile and investment objectives.  At this stage it’s also important to ensure that exposure isn’t confined to a single sector of the equity market.  This ensures a balanced approach and cushions against market events that could adversely affect a particular sector of the equity market.

Step 6:  Monitoring the portfolio

A risk profile is not cast in stone;  it changes over time due to changes in the investor’s personal financial circumstances.  When it changes, the strategic asset allocation should change as well.

Monitoring the portfolio also means re-balancing the asset class exposure when required.  This is because market movements can cause exposure within the asset classes to move outside the strategic asset allocation bands due to one class performing better or worse than another at a particular point in time.

Also important when reviewing the portfolio is to pay attention to the performance attribution generated by the various funds.  For example, are your chosen funds performing as you expected them to, and in accordance with their mandate and objective?

Investors are encouraged to consult a qualified financial intermediary who can provide objective advice, as although the process described in this article is relatively simple, it’s not always easy.  In addition, using the services of a financial intermediary brings discipline to the planning process. Glacier provides assistance and support to intermediaries with the above process through various publications and software tools.

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