As an investor, the greatest concern is growing your investment to deliver higher risk-adjusted returns. Risk-adjusted return hones an investment’s return by measuring how much risk is involved in producing that return, the risks could be as a result of prevailing economic environment brought about by the cyclical nature of investments markets due to varying macroeconomic factors like politics, inflation and country growth. It is therefore important to know how to determine an asset allocation that best suits your personal investment goals and needs.
Your portfolio should thus be constructed in a way that guarantees you can meet your future financial needs while delivering the best returns. In today’s financial marketplace, there are various investment options which range from fixed income, equities, real estate, structured products to others such as derivatives and private equity investments. So, out of all the available investment options, how do you determine the best mix to deliver higher-risk adjusted returns for your portfolio? This involves conducting an analysis of your investment objectives and constraints in order to inform the investment strategy.
Here are factors to take into consideration in determining the best mix for your investment options.
This is the probability that an investment may not earn its expected rate of return. For investors, it is of paramount importance to figure out your risk tolerance level i.e. your capacity to take on risk, and not just your willingness to bear risk. Generally, the approach is usually to conform to the lower of the investor’s ability or willingness to take on risk. To gauge your risk profile, it would be highly encouraged that you take a risk profiling test from your investment advisor to avoid subjectivity.
This is the expected earnings from an investment; they include dividend, interest, rent, capital appreciation etc. Getting returns is the core reason for investing. Generally, the higher the risk an investor takes on, the higher the expected return, and the lower the risk, the lower the expected return.
This refers to how quickly an asset can be converted into cash without a significant loss in value. An investor who requires regular cash flow to fund possible expenditure needs may require liquid assets to be held in their portfolio.
This refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time. Other than risk, the return on an investment is also influenced by its level of volatility.
5. Investment horizon
This refers to the period that an investor intends to hold an investment, and it is dependent on the investors’ income needs and risk profile. In general, the longer an investor’s time horizon, the more risk and less liquidity (especially in case of alternative investments such as real estate and private equity) the investor can accept in the portfolio.
6. Sophistication of the investor
This refers to how knowledgeable an investor is in terms of investment products and their capacity to invest. Usually, investment products are classified into retail investment products and institutional investment products, with some investment products being suitable for all classes of investors, while others are tailor-made to target a specific class of investors. The more knowledgeable you are about an investment product the better the chance of you making the right decision in respect to your portfolio.
7. Tax situation
The tax treatment of various types of investments is also a consideration in portfolio construction. Some investment accounts like pension accounts may be tax exempt, hence investors with such accounts can choose fully taxable securities to hold in their portfolios. For accounts that are fully taxable, investors may opt for investment securities that are taxed at lower rates, e.g. investing in equities for capital gains that are usually tax exempt or taxed at lower rates.
8. Unique circumstances
Each investor may have specific preferences or restrictions on which securities and assets that they can invest. These can range from ethical preferences, religious preferences or restrictions placed on investing in rival companies.
Constructing your investment portfolio
After analyzing an investor’s investment constraints, the next step is to construct the investment portfolio, taking into account the importance of diversification to minimize risk in the portfolio. The investment portfolio can be constituted of a variety of asset classes which include:
a. Fixed income
These are securities that promise to pay a given return to an investor, in the form of coupon payments and repayment of principal on maturity. They include Treasury bonds and bills, corporate bonds and fixed deposits in financial intuitions. Key characteristics that make it appealing to investors under various macroeconomic conditions include:
- They cover short to medium term investment horizons, and exhibit low volatility and hence suited to investors who desire stable returns and are risk-averse.
- They are highly prone to changes in interest rates. Thus, when interest rates are rising, more investors are attracted to the fixed income market owing to higher yields.
Equities refer to ownership of interest in an entity in form of common or preferred stock. Other than capital gains, equity investors also stand to gain from dividends declared by a company if they are in the shareholders’ register at the time of book closure. Key characteristics that make it appealing to investors include:
- Liquidity: Listed shares are relatively liquid in that investors can easily convert their investment into cash for immediate use within a short period depending on the trading settlement cycle,
- Volatility: Stocks are the most volatile asset class as market forces of demand and supply determine their value. This characteristic makes equities preferable for long-term investors who can hold the stock through the short-term volatility, until the stock price attains its intrinsic value. This characteristic also makes equities appealing when there is positive macroeconomic news as optimism among investors usually results in a rise in stock prices.
c. Real estate
This refers to investment in property for returns. The investment could either be in residential, commercial, retail, industrial properties, among others. Key characteristics that make this asset class appeal to investors under various macroeconomic conditions include:
- Diversification: Real estate investments do not move in tandem with the public listed markets, hence has low correlation with traditional investments, a factor that enhances diversification benefits.
- Reduced volatility: The inclusion of alternative investments in an investment portfolio tends to result in lower overall volatility of the portfolio.
- Superior returns: Alternative investments have historically outperformed traditional investments. For instance, real estate which is an alternative investment asset class, has consistently proven to outperform other asset classes in the traditional asset classes.
As an investor you should have an inquisitive approach and take an active role in managing the portfolio to analyze your individual investments and determine if they are worth holding, since a well-diversified portfolio reduces risk without sacrificing returns. Despite the many proven benefits of diversification, it is important to note that it does not guarantee an investor protection against a loss. In addition, diversification does not reduce the non-diversifiable risk of investing in a particular market.
Non- diversifiable risks include: inflation rate risk, exchange rate risk, political instability risk, and interest rate risk, which are the risks investors must accept willingly in order to invest. Considering all these factors in an investment strategy, it can be challenging especially if you are not involved in investment management on a daily basis and hence the need to partner with an investment professional, who will assist in coming up with your own specific investment portfolio. The professional will help in:
- The generation of an Investment Policy Statement (IPS); serves as a strategic guide to the development and implementation of an investment plan.
- The actual construction of the portfolio and security picking.
- Periodical review of your portfolio to allow for rebalancing to your target allocation.