Steps to Develop the Strategy
Now that you have identified your investment objectives and constraints, and we’ve arrived at an educated set of market assumptions, we will discover the steps to create your ideal investment strategy.
Strategic Asset Allocation
Once your objectives and constraints are determined, and we have a set level of expectations, we are ready to set our strategic core asset allocation.
We recommend following a top-down approach to creating your portfolio. This means that we will start by looking at the bigger picture allocation (taking a macroeconomic view and an overall allocation) and then we will progressively get down to the details (security selection). We have seen the first big-picture step, the Capital Market Expectations, which is a general macroeconomic analysis of possible outcomes. Now let’s see the following steps to create the portfolio:
Overall Portfolio Allocation
The first and most important matter you have to tackle when creating your asset allocation is the proportion of your total investment capital that you will want to allocate to risky assets (such as stock, bonds, etc.) as opposed to safe assets (such as short-term Treasuries, etc.).
This initial decision will be based on your level of risk tolerance and will ultimately define your portfolio performance. Let’s see an example of this to get the point across:
- Jim is looking to invest $2,000 and, as we have seen on his investor personality table, he prefers to play it safe and avoid as much risk as possible while growing his investments steadily. Therefore, he may decide to allocate 40% ($800 of the total $2,000) of his investments into risky assets (such as stocks or high yield corporate bonds) and 60% ($1,200 of the total $2,000) to safer assets (such as investment-grade bonds or government bonds)
- Hannah, on the other hand, wants to invest $1,000 and try to generate higher returns, as she is willing to take on extra risks. So, she may choose to invest 90% of her capital in risky assets and 10% in safer options.
Core asset class allocation
Once you have decided on the overall distribution of your capital (towards risky or safer options), it is time to make the actual asset allocation decision. This is perhaps the most important step in building a portfolio since most of your portfolio’s performance (success or failure) is attributed to your asset allocation (and not so much to your security selection).
Knowing and understanding how asset classes behave is important to make the right allocation decisions. As we have seen before, your portfolio may be comprised of some combination of the following core asset classes (not a full list):
- Cash & equivalents (Money-market securities)
- Real estate
In previous sections, we have started discussing these asset classes and how they behave. If you want to know more about them, check out these sections.
The asset class mix you choose should match your risk tolerance and your goals, which may change over time. Therefore, your core asset allocation should be consistent but not rigid, it should adapt to your everchanging objectives and constraints.
Let’s continue with the above example to see how this can be applied:
Before moving down to security selection, we must take an important step to get a bit more specific in what we want in our portfolio:
Sub-asset class allocation
This is a crucial step in getting your portfolio strategy set up. Now that we have the core asset classes mix, we can get more specific to determine what we actually want our portfolio to be exposed to on a granular level.
In previous sections, we have talked about how asset classes (like stocks) are broken down into sub-segments (sub-asset classes) to provide more detailed analysis and exposure for investors.
We believe that choosing the right sub-asset classes can help you achieve a well-diversified portfolio.
We discussed some of the different ways investors can get sub-asset class diversification when we went over mutual funds and ETFs. These investment vehicles allow us to get the right amount of exposure to the sub-asset classes we believe are best for us.
ETFs and mutual funds are available for an incredibly wide range of asset classes and sub-classes and they help us own diversified professionally managed portfolios at a very low cost.
If you are not very experienced in investing, or you have little time to keep track of it constantly, creating a portfolio of ETFs may be the way to go. This way, you avoid the hustle of actively analyzing and picking assets (we will see this next).
If we continue our example, you may see where we are going with this:
Jim doesn’t have a lot of expertise in the world of finance and prefers sticking to ETFs instead of picking stocks. We will just focus on his sub-asset class allocation in this example to bring the point across:
The above visually helps us see Jim’s allocation strategy. In blue, we have the risky section of his portfolio:
We can identify the top-down approach he too by starting with a darker blue and progressively getting more specific with a lighter blue.
He broke down his 30% allocation to stock evenly into 3 different sub-asset classes (10% to US Large Cap, 10% to Consumer Staples Sector and 10% to International Growth). Then, he decided to allocate 5% to US Commercial Real Estate and 5% to Gold.
As for the safer assets, in his 50% allocation to bonds, he went for 20% to Investment-Grade, 20% in US Gov. Long-Term and 10% in Int’l Corporate. Lastly, he allocated 10% to US T-Bills.
This is a good example of a well-diversified portfolio that will most likely help Jim achieve his goals. Now, all he has to do is look for good, cheap ETFs that represent the sub-asset classes he chose.
If you want to learn more about how to do that, check out our amazing content.
In the next section, we will discuss how to pick securities and more.