Portfolios consist of financial products where assets may or may not be correlated. This is what makes for an objective portfolio with inherently designed risk reduction and expected returns. The importance of diversification, and positive and negative asset correlation with associated risk returns are important to consider in portfolio design. Periodic rebalancing of a portfolio allows the investor’s original intent to remain true to its intended design and correct for asset drift.
Factor-based investing, risk return, and asset correlation Factor-based investing has become an accepted investment philosophy in academic circles. Factor-based investing aims to harvest these risk premia through exposure to factors. These may include value, size, volatility, quality, and momentum. A factor can be any characteristic relating to a group of securities that is important in explaining their return and risk. Academic research highlights that long-term equity portfolio performance can be explained by factors, and this research has been prevalent for over 40 years.
Certain factors have historically earned a long-term risk premium and represent exposure to systematic sources of risk. This methodology may help investors make informed decisions about various investment approaches and allow for improved investment results over time. According to insights.som.yale.edu, “By focusing on the underlying factors that define risk, return, and correlation, this approach seeks to explain why some asset classes move together to offer more efficient portfolio construction.”
In reality, there exists hundreds if not thousands of potential assets to select from and invest. The most commonly known are large, medium, and small cap, emerging market, international and other index funds (many with specialized subsets), S&P, and ETFs. If investing in mutual funds, it’s important to ensure the fund manager adheres to the prospectus and the stated percentage of assets included in the fund to avoid fund drift. Deciding to invest in any asset class has an inherent risk-return component, with accompanying expected returns for taking the risk. Funds with higher risk may presume to offer greater returns, but at the same time may result in greater loss. This is defined as standard deviation. The concept of diversification becomes an important and pragmatic approach to investing.
Don’t put all your eggs in one basket
Diversification is important because it spreads risk over a broad amount of asset classes. Diversification helps reduce and cushion any asset value loss vs. losing the entire value. Any investment, whether conservative to aggressive, has risk, and every investor is exposed to some form of risk. The key is to mitigate the risk and attempt to maximize the return, and to do this within an agreed to investing tolerance. Diversification is a personal decision, and is often determined based on prior investing experience or philosophy, market turbulence and accompanying tolerance, or (not advisable) the flip of a coin. Diversification and periodic rebalancing have been shown to be the most objective, even-handed, and proactive approach to investing.
Working collaboratively to help ensure success
Portfolio management usually begins with an Investment Policy Statement (IPS). The IPS is the roadmap the advisor and client use as the portfolio is established. An investor should receive timely statements clearly illustrating the return of investment and the overall return. A fiduciary Certified Financial Planner places the need of the client before him or herself vs. selling a product that at face value appears to be suitable for the client. A CFP advisor works in conjunction with a Chartered Financial Analyst (CFA) to ensure the client receives an objective overview of the selected asset classes. This results in a well-designed portfolio composed of assets and anticipated risk-reward returns based on the IPS.
Whether financially self-directed or working with a fiduciary advisor, transparency, full-cost disclosure, knowing your goals and expectations, being realistic with results, and understanding your financial personality traits are a good combination for achieving your bottom line results without second guessing yourself. Being honest with one's self and taking a life inventory of situations and anticipated changes leads to a realistic approach to investing and establishing goals. Proper financial planning allows your investments to work for you. Adding factor-based investing will help you reap the rewards of prudent investing.
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