A primary goal of many investors will be to have a so-called ‘perfect’ stock portfolio, one which optimises potential reward for the risk being taken on by the investor.
It should of course be noted that even in a stable environment, it is hard to define what a so-called ‘perfect stock portfolio’ is, given that there are so many different exposures available, and a huge amount of data and company information to be digested. What might appear to be the ‘perfect’ stock portfolio to one investor with a particular set of investment objectives could prove to be unattractive to another investor. As the market dynamics change, the relative ‘perfection’ of a portfolio would also change as a portfolio designed to be ‘perfect’ during the growth stage of the market cycle could be far from perfect during a market downturn.
Essentially, the future is uncertain, and no portfolio can be perfect during all periods because it cannot meet all its stated objectives in every situation. The perfect portfolio today is really just a snapshot of what’s best for investors at the moment and in the current environment. The pursuit of the perfect portfolio is about adapting to the current income, spending habits, and financial goals of an investor, along with the market environment, and expected returns in the market.
The market portfolio is a theoretical bundle of investments that includes every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market. A market portfolio, by nature of being completely diversified, is subject only to systematic risk, which is the risk that affects the market as a whole, and not to idiosyncratic risk, which is the risk inherent to a particular asset class or company. In other words, the unique risks associated with a specific company or industry are almost completely diversified in a market portfolio. As a result, under the capital market theory the market portfolio is the most optimal portfolio, providing the highest Sharpe ratio and the highest additional return over risk-free rate for each unit of additional risk taken. A key limitation of the market portfolio however is that it is impossible to create a truly diversified market portfolio in practice—because this portfolio would need to contain a portion of every asset in the world, including collectibles, commodities, and basically any item that has marketable value. This argument suggests that even a broad-based market portfolio can only be an index at best and as such only approximate full diversification. As a result, proxies for the market, specifically market indexes such as the S&P 500 in the US and the ASX 200 in Australia are used by investors. While these proxies cannot provide a completely accurate representation of the entire market, they often constitute a cross-section of businesses that in the aggregate are bound to do well. The average annualized return on the S&P 500 since its inception in 1926 through 2021 is 10.49%. Adjusted for inflation, the historical average annual return is around 7%.
An example of this type of portfolio is Warren Buffet’s outlined 90/10 portfolio outlined on page 20 of his 2013 letter to Berkshire Hathaway Shareholders:
Buffet explains that a broad market index like the S&P 500, which also happens to be very cheap to own via index funds or ETFs, is an ideal investment strategy for most investors who lack significant experience and knowledge, and the approach avoids high fees and expenses associated with active strategies. The potential drawback of this portfolio is that is exclusively invested in the U.S and some international diversification is preferable. Additionally, while it is an investment that would avoid large systematic risks, it also misses stronger outperformances which can be achieved with the help of an adviser.
Investors with significant market experience and greater risk tolerance may select tactical allocations depending on in order to generate alpha which refers to excess returns earned on an investment strategy above the market index.
While investing in a fund that replicates the market index is a common strategy, there are many ways to invest. These strategies will vary for investors depending on their goals for the future, appetite for risk, and personal contextual factors. The following are four broad types of investment portfolios:
Defensive – Defensive stocks do not usually carry a high beta.They are relatively isolated from broad market movements. Unlike cyclical stocks, which are sensitive to the underlying economic business cycle, defensive stocks tend to do well in bad times as well as good times. No matter how poor the economy is generally, companies that make products that are essential to everyday life should continue to perform strongly, at least relative to other companies. The aim of this type of portfolio is to protect the principal (or initial investment), and only then add excess returns. A defensive portfolio is a prudent choice for some investors and an ideal option for investors aiming at minimizing risk in exchange for only minimal returns.
Aggressive – An aggressive portfolio seeks to beat the broader market's returns and accepts the increased risks that go with that sort of strategy. Stocks for this kind of portfolio typically have a high beta or sensitivity to the overall market. This comes as high beta stocks experience greater fluctuations in price than the overall market – both to the upside, and the downside. Aggressive investors seek out companies that are in the early stages of their growth and have a unique value proposition. With the presence of a high beta, the advantage of stock market fluctuations is taken to earn profits that hopefully beat the market. Investors have to monitor the portfolio regularly in order to manage the high amount of risk, and this sort of portfolio is recommended.
To build an aggressive portfolio, investors will look for companies that have rapidly accelerating earnings growth, and it is preferable if these positions have not yet been discovered by the average investor. These companies are most often found in the biotech and technology sectors, but they can be found in other industries as well. Risk management is critical when building and maintaining an aggressive portfolio. Keeping losses to a minimum and taking profit are the keys to success in this type of strategy.
Income – An income portfolio focuses on investments that make money from dividends or other types of distributions to stakeholders. Some of the stocks in the income portfolio could also fit in the defensive portfolio, but here they are selected primarily for their high yields. Real estate investment trusts (REITs) and master limited partnerships (MLP) are examples of income-producing investments and tend to return a large share of their profits to shareholders in exchange for favourable tax status. REITs, in particular, are a way to invest in real estate without the complications of owning real property.
Speculative – Often considered one the riskiest investment strategies, as the investment decision is made prior to a relatively binary event, which could either make the initial investment look like a bargain or an overspend. It is expected that breakthroughs will be created in the market because of regulatory approval being announced or a changing business strategy. For example, an early-stage mining company about to release its initial results would be a speculative investment, as would a Healthcare company whose future prospects are strongly reliant on gaining FDA approval, which is a significant risk. Similar to aggressive portfolios, the risk component is high and simultaneously the returns are also high. A speculative portfolio is the one choice that requires the most research if it is to perform successfully. Speculative stocks are typically traded frequently and not classic buy-and-hold investments.
A common theme across all of these strategies is that they include a certain level of diversification either internationally, across different sectors, or exposures. Investors diversify for the same reason street vendors often sell seemingly unrelated products, such as umbrellas and sunglasses - by including securities with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Using the street vendor analogy, it may seem odd to sell both products as a person will not buy both items at the same time. However, street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. Conversely, when it’s sunny, it is easier to sell sunglasses. By selling both items - in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.
Similarly, by including securities from sectors whose performance reacts differently under different market conditions within a portfolio, an investor can protect against significant losses. Market conditions that cause one type of security to do well often cause another type to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride – both to the upside, and the downside. If one portion of the portfolio’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category. The active allocation strategy relies on the forecasting of upcoming market conditions and seeks to overweight and underweight specific industries and companies, depending on the investor's predictions.
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