A New Year (And Old Challenges)

What are the primary challenges for designing and managing portfolio strategies in the new year? The same ones that bedeviled us in 2013. At the top of the list is a tendency to overlook the portfolio and instead focus on the individual pieces that collectively add up to “the strategy.”

Markowitz long ago told us that “Portfolio Selection” is the holy grail of investing decisions. But you can’t embrace this strategic advice unless you spend time thinking of your various investments as one aggregated fund. That’s harder than it sounds, in part because the world is constantly inviting you to focus on the parts rather than the whole. It’s unsurprising that portfolio perspective is forever in short supply in the wider world of analysis and news. Asset allocation design and management scream out for customized solutions. In other words, you’ll have to do most of the work yourself in the critical cause of analyzing and monitoring your investments from a top-down portfolio perspective.

Where to begin? The first order of business is generating returns for your portfolio. The good news is that there’s no shortage of tools (often at no charge) on the web. Morningstar’s Portfolio Manager is one example (click on the “Portfolio” tab at the top of Morningstar.com). Regularly monitoring how your portfolio ebbs and flows in absolute and relative terms is essential. Every portfolio has a unique risk and return profile. The question, of course, is whether the profile that defines your portfolio is appropriate for you?

Developing confidence that you’re on the right track is a process, and one that takes time and regular monitoring. No wonder that many investors choose to hire a financial advisor. If you’re inclined to do it yourself, you’ll need a plan to stay on the straight and narrow. Portfolio analysis can easily turn into a black hole if you’re not careful. Creating a blur of data in the 21st century is about as difficult as walking, which is why prioritizing your analytical path is so critical.

The foundation is calculating returns, of course. For most investors, simply reviewing how the portfolio has performed can be an eye-opening experience. Assuming your strategy is reasonably diversified, there’s a good chance that the monthly results will be closely correlated with a naïve portfolio of betas, such as the Global Market Index. The priority is deciding how, or if, to adjust your portfolio’s risk and return profile through time. Again, this isn’t a one-time decision; it’s a process, and one that can only be intelligently managed by routinely dissecting the portfolio.

In other words, you need good data on how the portfolio is evolving. Consider a simple 60%/40% US stock/bond portfolio. Let’s say that we created this portfolio with a pair of ETFs (SPY and AGG), with an inception date of Dec. 31, 2003. You might think that’s there’s not much to consider with such a basic investment strategy. In fact, there are multiple perspectives to review in the search of valuable context. For instance, here’s how the rolling 1-year correlations between the two ETFs compare for the past decade, based on 90-day windows for trailing 12-month returns (plotted daily):

If you owned this portfolio, what might the correlation history imply about adjusting the mix? Do high correlations between the assets offer more opportunity for portfolio changes? Or should we emphasize low correlations as the basis for timely adjustments? Is a 90-day look-back window superior to a longer period? Should we analyze return correlations based on one-year returns—or three- or five-year returns?

Before you go off the deep end on any analytical pursuit, keep in mind that the key decisions for any portfolio can be reduced to: 1) choosing the initial asset allocation; and 2) deciding how and when (or if?) to rebalance. Analytics should be designed and implemented with the goal of providing useful information to help us make better choices about these two aspects of portfolio management. Everything else is usually noise.

As challenging as this task is, it’s a lot tougher if you’re easily distracted by the media’s focus on the parts rather than the whole. It’s tempting to think that the financial story du jour is the most important piece of intelligence for managing your investments. But ask yourself some simple but important questions: How much do you know about your portfolio’s risk/return profile? How does it compare with a passive benchmark for a comparable strategy? What does the risk/return profile imply about how, or if, you should change your asset allocation and/or rebalancing strategy?

The more you think about these critical questions (and how to come up with intelligent answers), the more you’re likely to recognize that most of what’s served up by the usual suspects in the media is irrelevant for building and managing investment portfolios that will help us achieve our financial goals with minimal risk. In this respect, the new year promises to be more or less unchanged from 2013.