INVESTING IS OUR STRONG SUIT

A daily column on investing by Orbis Investment Management Limited

You may meet a senior representative from Orbis Investment Management Limited at the hotel. To make an appointment please contact the hospitality desk or call the Churchill Suite, room phone: 7554.

Building Portfolio

This article will discuss the structured approach investors take when building a portfolio of securities. Before we start however, it is important to explain why the topic "building a portfolio" deserves any attention. A simple approach to building a portfolio is to select those securities that are expected to offer attractive returns and invest in each based on the size of the expected returns.

Unfortunately portfolio construction is not this simple. The simple approach largely ignores potential risk when constructing the portfolio. It turns out that if both risk and return are considered at the same time, a portfolio can be produced that will offer a much higher expected return for a given level of risk than could have been achieved by simply concentrating on returns. To manage the consideration of risk and return, portfolio construction is frequently broken down into two steps.

Asset allocation

The first step, known as asset allocation, considers the risks and returns of potential asset classes and selects appropriate weights for each asset class. For example, a very conservative investor might distribute his portfolio 20% in cash, 50% in bonds and 30% in equities. In contrast, an investor who is prepared to take much more risk might have an asset allocation that placed more weight in equities for example 5% cash, 25% bonds, and 70% equities.

The appropriate allocation between asset classes depends on the given investor's risk tolerance, his return requirement, the expected returns of each asset class, the risk or volatility of each asset class and a measure of how much the different asset classes move together.

The portfolio manager takes all this information and uses it to construct an optimal asset allocation for that investor. This would be a huge amount of data if not reduced to asset classes first. For a portfolio of 50 securities there are 1,225 correlations between the individual securities. Sophisticated computing techniques help to calculate the best asset allocation. Usually, the portfolio manager combines the results of quadratic optimization with data that reflect additional investor constraints, the liquidity requirements of the portfolio and the status of the current portfolio if this already exists.

Security Selection

Once capital has been allocated to each asset class, the portfolio manager then takes the second step of selecting individual investments from within each asset class. Again the manager needs to allow for return, risk, liquidity, and investor constraints when making this selection. The aim of this process is the same as that in the first step, namely to generate the maximum return for the portfolio for a given level of risk

Alternative Portfolio Construction Methods

It is entirely valid to construct a portfolio without going through the asset allocation step. A manager could simply take a wide range of different investments and select weights for those investments that produced an optimal portfolio. This has the advantage of allowing all risk and return information to be considered at once which, in theory, should produce a portfolio that is superior to that resulting from the two step construction process. In practice, however, this approach requires very high quality data that is not normally available.

Diversification-when and how far to spread your risk

So we have seen that diversification can be used to improve the returns of a portfolio for a specific level of risk. However there are limits to the benefits of diversification. The most significant is that the risk reduction gained by diversification declines as the number of investments in the portfolio increases.

For example, a portfolio that increases its number of holdings from 10 to 20 investments experiences a significant decline in risk (assuming the investments have the same volatility and are uncorrelated). Not only does the impact of each incremental holding diminish, it also becomes difficult to find new investments that do not share some similarity of returns with the ones already held. A portfolio that increases the number of its holdings from 90 to 100 should not expect its market risk to decline by very much at all.