The Money Scope Podcast
Ep. 7: Portfolio Design & Management
Podcast summary created with Snipd AI
Quick takeaways
- Asset allocation is crucial for portfolio management, balancing risk and returns.
- Behavioral biases and emotional decision-making can negatively impact investment returns.
- Taking a long-term perspective and focusing on investment strategy are key to successful investing.
- Market highs are usually followed by more highs, so fear of missing out can be detrimental.
- Portfolio rebalancing is essential for controlling risk and maintaining the desired asset allocation.
Deep dives
The Risk-Return Tradeoff and Asset Allocation
Historical data shows that riskier assets tend to have higher expected returns. This relationship between risk and expected return is observed globally and over long periods of time. Longer-term bonds have outperformed shorter-term bonds, and stocks have outperformed bonds. Within stocks, riskier assets, like value stocks, have historically delivered higher returns. However, it is important to note that taking on excessive risk may not be suitable for every investor and that volatility and behavioral factors need to be considered.
Understanding Volatility, Risk, and Expected Returns
Volatility, or price swings, is commonly associated with risk in financial assets. However, risk encompasses various factors such as covariance with bad states of the world and conditional skewness. The relationship between risk and expected return is well-documented in historical data. Riskier assets often command higher expected returns, compensating investors for taking on additional risk. It is important to note that while riskier assets may offer higher returns, they can also be challenging to own and may not always outperform safer assets in the short term.
Behavioral Risk and Investor Biases
Investors are prone to behavioral biases and errors that can negatively impact their returns. Common behavioral errors include overtrading, performance chasing, and letting emotions drive investment decisions. Investors often evaluate their portfolios on short time horizons and are driven by fear of losses and the desire to avoid pain. This can lead to suboptimal investment decisions, such as selling investments after they have declined in value or holding onto losing investments for too long. Understanding and managing these behavioral biases is essential for successful investing.
The Importance of a Long-Term Perspective
Taking a long-term perspective is crucial in investing, as it allows investors to better navigate market volatility and overcome behavioral biases. Short-term market fluctuations should not overshadow the long-term expected returns of a well-constructed portfolio. It is vital to focus on an investment strategy that aligns with an individual's financial goals, risk tolerance, and time horizon, rather than succumbing to short-term market noise and emotional reactions.
The importance of market highs and the fear of missing out
Investors often worry about market highs and fear missing out on future gains. However, historical data shows that all-time market highs are usually followed by more highs rather than declines. Selling out of fear and missing out on potential gains can be detrimental. Timing the market by selling before a drop and reentering when it recovers is challenging. Fear of missing out (FOMO) often influences investors' decisions, especially when influenced by peers and influencers. Attention-grabbing stocks and funds can have negative future returns. Behavioral gaps, the difference between fund returns and investor returns, can be substantial due to emotional decision-making. Diversification and automation can help shrink the behavioral gap.
The impact of risk tolerance on asset allocation
Risk tolerance depends on the ability, willingness, and need to take risk. Ability to take risk is influenced by financial stability and time horizon. Willingness to take risk is subjective and can be affected by emotional responses to market volatility. Need to take risk is determined by financial goals and expected returns. Running financial planning projections can help determine the ideal asset allocation based on risk tolerance. Vanguard's investor questionnaire and other tools can be useful in assessing risk tolerance.
Choosing an asset allocation
Choosing the right asset allocation involves considering risk capacity, risk tolerance, and financial goals. Tools like Vanguard's investor questionnaire can provide a starting point. The asset allocation should balance expected returns and volatility, taking into account individual circumstances and long-term goals. It is important to avoid analysis paralysis and make adjustments based on experience and new information.
Portfolio maintenance and the importance of rebalancing
Portfolio maintenance involves rebalancing to keep the portfolio on target. Rebalancing involves selling assets that have grown more and buying assets that have grown less to maintain the desired allocation. Rebalancing can be done through new contributions or by selling assets if the portfolio is large. Asset allocation ETFs can simplify rebalancing. Financial advisors can assist with portfolio rebalancing. Regular monitoring and rebalancing of the portfolio ensures it stays aligned with the desired asset allocation.
Importance of Rebalancing to Control Risk
Rebalancing is crucial for controlling risk in a portfolio. Neglecting to rebalance can lead to an outsized allocation to certain assets, increasing the risk beyond what was intended. For example, if an investor's target allocation is 50% stocks and 50% bonds, but the portfolio becomes 80% equities over time due to neglecting to rebalance, the risk exposure becomes considerably higher. Rebalancing is not done to boost returns, but rather to maintain the desired risk level. It allows investors to avoid larger losses and helps them stick to their investment plan over the long term, improving behavioral performance.
Frequency and Approach to Rebalancing
Determining the frequency and approach to rebalancing requires a balanced approach. Rebalancing can be done based on a schedule, such as once a month or once a year, depending on individual preferences and the availability of funds. It can also be triggered by a threshold, where if the asset allocation deviates beyond a certain limit, rebalancing is necessary. The choice of approach depends on various factors, including transaction costs, effort, and potential errors. Vanguard's research suggests that rebalancing annually with a 1% guardrail is optimal. The study shows that the differences in portfolio growth due to different rebalancing strategies are relatively small, emphasizing the importance of rebalancing rather than the specific approach.
Picture your investment portfolio as a carefully crafted puzzle and asset allocation as the key to solving it. It not only helps you navigate the treacherous waters of risk but fine-tunes your investments to harmonize perfectly with your financial dreams. In this episode, we take a deep dive into the art and science of portfolio management. Discover the intricacies of portfolio planning, execution, and maintenance as we dissect this critical aspect of wealth management. We unpack asset allocation with a focus on the stocks-to-bonds ratio, a crucial decision that balances the quest for maximum returns with the need for stability. We uncover the dangers of volatility and behavioural risks and explore strategies to safeguard your financial health. Tuning in, you’ll hear how assessing your risk tolerance and automating tasks can lead to a well-crafted portfolio (and why we suggest using a portfolio manager). We also guide you through the maze of asset allocation options and the vital steps for effective portfolio maintenance. Whether you're a seasoned investor or just beginning your financial journey, this episode will equip you with the knowledge you need to navigate the complexities of portfolio management with confidence, so be sure to tune in for expert insights, practical strategies, and actionable advice that will empower you to make informed decisions about your financial health!
Key Points From This Episode:
(0:03:55) Portfolio planning basics, an overview of risk, and the goal of asset allocation.
(0:08:07) Unpacking the concept of ‘optimal portfolios’ and why it is not achievable.
(0:14:13) Essential asset allocation aspects, the role of human capital, and strategies to manage risk.
(0:20:41) Individualized job skills and their impact on asset allocation in the broader economy.
(0:24:54) How social capital plays into asset allocation from an investment standpoint.
(0:28:25) Risk expected return, correlation of assets in a portfolio, and the different types of risk that should be considered.
(0:36:03) Using historical returns for forecasting expected returns and the nuanced ways that behaviour drives investment decisions.
(1:04:04) Applying asset allocation principles to construct a diversified, market-efficient portfolio (plus some common pitfalls to avoid).
(1:19:13) Trade-offs of a less volatile portfolio and a framework for risk tolerance calculation.
(1:34:45) Fundamentals of good portfolio maintenance and how to protect your investments.
(1:50:36) Navigating portfolio execution errors and the portfolio pyramid.
(1:56:32) Closing comments and important takeaways from the episode.
Links From Today’s Episode:
https://moneyscope.ca/2024/02/09/episode-7-portfolio-design-management/
Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/
Benjamin on X — https://twitter.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Dr. Mark Soth (The Loonie Doctor) — https://www.looniedoctor.ca/
Dr. Mark on X — https://twitter.com/LoonieDoctor
Rational Reminder Podcast Episode 100: Professor Kenneth French — https://rationalreminder.ca/podcast/100
Rational Reminder Podcast Episode 224: Professor Scott Cederburg — https://rationalreminder.ca/podcast/224
Rational Reminder Podcast Episode 258: Professor Meir Statman — https://rationalreminder.ca/podcast/258
Rational Reminder Podcast Episode 260: Professor James Choi — https://rationalreminder.ca/podcast/260
Rational Reminder Podcast Episode 262: Professor Francisco Gomes — https://rationalreminder.ca/podcast/262
Rational Reminder Podcast Episode 263: A Tribute to Harry Markowitz — https://rationalreminder.ca/podcast/263
Morningstar | ‘Mind the Gap’ — https://www.morningstar.com/lp/mind-the-gap
‘Long-Horizon Losses in Stocks, Bonds, and Bills: Evidence from a Broad Sample of Developed Markets' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3964908
Vanguard Investor Questionnaire — https://investor.vanguard.com/tools-calculators/investor-questionnaire
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