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Building an Investment Portfolio IV:

Portfolio Construction

Now that steps I, II & III have been tackled, the most challenging element of this whole process is next. Constructing a portfolio is never easy for many reasons. Not only are you attempting to incorporate all the earlier points, but possibly a few more depending on your situation. Getting here requires time, but you also need to spend the appropriate amount of time searching, filtering, analyzing and selecting which investments meet your set objectives. I consider four elements as extremely important for generating future consistent returns and I’ve weighted each appropriately depending on their level of importance. These 4 factors are comprised of: Timing, Security Selection, Geographic Allocation & Asset Allocation.

Timing relates to the entry point into the market, stock or investment vehicle. In general practice I award this component only 2% of any future gain I make. Whether your opinion is of an efficient or inefficient market, the entry point over the long term may only add 1-2% to your overall success in the grand scheme of things. Whether you buy something for a few dollars more or less over the short term – it’s more important that you understand the fundamentals of your choices. The goal here is to not get the absolute cheapest or most opportune moment to buy. Waiting may result in missing a quality entry point or missing a decent dividend which after tax results in more than the yield of the stock. Balancing all of this out over the long-term, wherever your entry point may be when averaged out, will most likely have less impact on your returns than the other three components of this section.

Security Selection is important in relation to costs. Generally I give this component a weighting of 13% importance simply because of the savings possible when using the proper mix of a discount brokerage for stocks, mutual funds, index funds & ETF’s. What you want to do is focus on what will maximize your return over the investment horizon of the portfolio and look to limit what will restrict your earning potential. This includes paying only 1% per stock trade in commissions and focusing on which MF or ETF gives you the best opportunity to grow your investment. In my own practice, I only pay a higher MER for a manager who has proven to beat the index over the long-term or who has experience or exposure to an area of the global market I know little or nothing about. I am willing to pay a small premium overall for an anticipated higher return than an index I hold little understanding of. That being said, I have never held a fund with an MER of 3% and have difficulty justifying anything over 2%.

Geographic Allocation is given a weighting of 35% in importance to a portfolio. You never want to hold 100% of your assets in one country or market strictly because of the element of risk that is involved. When one market is up, another may be down and it’s important to realize that DCA (dollar cost averaging) your investments can have a huge impact on long-term returns. This means that although one market may be up substantially over the short-term, you’re properly diversified against risk if the environment changes in that market. You also want to look at your sector breakdown and whether you’re over or under exposed to a certain industry.

Asset Allocation is the final component and I weight this component with the remaining 50%. The importance here is to realize that the weighting of assets in your portfolio will have a dramatic effect on not only the potential to grow your investment, but also to buffer against risk and volatility. Although some people may be 100% equities over the short or long-term, that may not suit your objectives and having a fixed income component to moderate volatility of your portfolio will go a long way to allowing you to create the patience needed to succeed in the markets. Remember that you never want to be overexposed or vulnerable to a certain asset class regardless of market conditions. You may miss out on an extra 4-5% by applying a more conservative stance, but over the long-term you are protecting your investment from any potential for deep losses.

As you progress through this, the final small elements you may wish to incorporate into your strategy revolve around testing different strategies, teaching yourself patience and selecting an appropriate benchmark in order to compare the returns of your portfolio to that of the general market.

Remember that investing SMARTER will go a long way to generating consistent long-term results. Although your investments may go up or down with the general market, the trend should be continuing to climb and allowing money to work for you. None of this is rocket science and frequently I feel that financial professionals do little in the way of educating their clients for the simple fact that if you learned what you need to know…they’d be out of business.

See Also:
Building an Investment Portfolio:
Part I
Part II
Part III

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