Portfolio construction has an important part to play in the investment world, but receives very little attention. It’s a shame because it can make a huge difference to long-term performance as well as reduce stress to help investors stay the course.

This article looks at the benefits of building a balanced portfolio and the different ways it can be done.

It might sound obvious, but a good starting point when building a portfolio is to have a clear idea of the returns you are aiming for, the time frame involved and how much risk you are prepared to take to achieve your goals.

There are many different types of assets to choose from beyond equities, including fixed-income securities (bonds), commodities such as gold and oil, private equity, property and alternative assets. Each will have different expected long-term return and risk profiles.

For this article we will focus on stock portfolios but look out for future articles where we will discuss the same principles as they apply to portfolios containing funds and multi-assets.

Let’s start by looking at a badly constructed portfolio to highlight some common mistakes and then offer some simple remedies.

WHAT IS A BAD PORTFOLIO?

Our hypothetical portfolio has a very large weighting in oil and gas shares with a particularly large position in Company F.

It might seem logical to put more money into the shares where you have the greatest confidence. It could be that you work in the oil industry and have a greater knowledge base.

There are two big problems with this approach, one psychological and one mathematical. In many experimental tests, so-called experts not only make poor forecasters relative to the lay person, but they also display massive overconfidence. So when they are wrong, they are very wrong.

Secondly, the heavy weighting in oil and gas means that the performance of three shares will determine the return of the whole portfolio, swamping the contribution from the other holdings. Any setback in the oil and gas sector could be devastating to your returns.

In addition, this portfolio is likely to fluctuate a lot, and academic evidence shows that this detracts from long-term performance. To illustrate the problem, a 33% loss requires a subsequent 50% gain just to get back to breakeven.

FIVE WAYS TO BUILD A BETTER PORTFOLIO

1.  DIVERSIFICATION

As the word suggests, diversification means simply spreading bets across a wide range of assets that behave differently to each other. It is a key part of the tool box that helps to reduce the fluctuation of the portfolio without detracting from its future returns.

Our bad portfolio doesn’t have any exposure to industrials, healthcare, telecoms, technology or utilities which would bring added variety to the line-up.

In addition, healthcare and utility shares tend to move around less than other areas of the market and provide good protection when market volatility increases.

2.  20 IS THE MAGIC NUMBER

Academics discovered long ago that adding more companies to a portfolio has the effect of decreasing its volatility. But, crucially there is a limit to the benefits, and that line is roughly 20 to 30 names. After that, adding more stocks will simply add cost without lowering the risk by very much. This is known as diseconomies of scale.

Simply speaking, portfolios that have more stocks are less prone to extreme performance.

Our bad portfolio needs far more companies in it to be considered properly diversified and is prone to extreme fluctuations.

3.  CONCENTRATION RISKS

One way of thinking about concentration risk is to look at the sector weightings of the benchmark and compare them to your portfolio.

A good rule of thumb is to limit exposure to the major sectors to plus or minus 50%. Applying something along these lines will act to reduce the volatility of the portfolio, without necessarily reducing returns.

For example, the oil and gas sector is around 16% of the FTSE 100 index, so using our guidelines the maximum weight in our bad portfolio would be 24% and the smallest weight would be 8%.

4.  SENSIBLE SIZING

It is important not to put too much of the portfolio into a single position. If you have a 30 stock portfolio and weight them equally, each stock would represent 3.3%.

A 20% fall in any single stock would only shave 0.66% off the value of the portfolio, and assuming that some of the others went up a little and some down a little, the overall performance would be acceptable, slightly up or down on the day.

It would be a different story with our hypothetical bad portfolio. Let’s say company F fell 20%; it would mean the portfolio was down 6.2% on a single day, and that’s before contributions from the other holdings.

Moreover if the reason that the company fell was oil sector-specific, then it’s likely that the other oil and gas names would fall in sympathy, exacerbating the loss.

5.  OTHER THINGS TO THINK ABOUT

Different investing styles come and go out of fashion and sometimes those trends can last for months and years. Growth and quality styles have been very popular since the financial crisis, at the expense of value, resulting in a wide performance gap.

It can therefore make sense from a diversification point of view to own a variety of styles of stocks, such as value, growth and momentum.

By applying a few simple concepts, it’s possible to reap the rewards from a well-constructed portfolio without detracting from good stock-picking skills.

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