NEWSLETTER

The building blocks of portfolio construction

This fact sheet explains the process of portfolio construction and how to construct an investment portfolio to maximise expected returns and minimise risk.

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Portfolio construction is a widely-used theory on how investors can construct investment portfolios to maximise expected returns and minimise risk. The practice of portfolio construction includes implementing an asset allocation strategy, which involves balancing investment risk and return by adjusting the percentage of a portfolio allocated to each asset class. Asset allocation is devised based on an investors risk tolerance, investment goals and investment timeframe. This fact sheet provides insight into the portfolio construction and asset allocation process.

What are asset classes?

In order to understand the portfolio construction and asset allocation process, it is useful for one to first learn about asset classes, which are the basic investment building blocks. An asset class is a term categorising financial assets that share similar characteristics. The four traditional asset classes are cash, bonds, equities and property. Cash as an asset class includes fixed deposit accounts, money market accounts and money market funds. It has the lowest risk of losing capital but the highest risk of losing purchasing power due to inflation. Bonds allow companies or governments to borrow money and pay it back, with interest, in the future. There are various types of bonds including government bonds, corporate bonds and municipal bonds. Equities are stocks or shares representing an ownership interest in a company. They are typically bought and sold on the stock market and their prices can therefore vary quite dramatically based on supply and demand. Property as an asset class offers diversification, with different performance characteristics and low correlation relative to the other asset classes. It can be in the form of listed property shares, property trust funds, direct property investment and property syndicates.

It is important to understand the differences between asset classes because they each have differing levels of risk and return and, as such, contribute differently to the overall return of an investment portfolio, as illustrated below. For example, cash is considered the lowest risk asset class, but it also provides a relatively low return when compared to equity.

Risk and return profile of different asset classes

High return Equity

Property

Bonds

Cash

Low return

Low risk

High risk

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What are the benefits and risks of investing in each asset class?
Macro-economic factors affect each asset class differently. This means that there are benefits and risks to investing in different asset classes, as shown in the table below:

Class
Cash

Benefits
Liquid asset providing stable growth Best for short-term conservative investors Returns have historically been better than cash Bonds are less volatile than equities The risk and return of property has historically been between that of equities and bonds but can outperform or underperform these asset classes at times. Often provides the highest return compared to the other asset classes, but also often at the highest risk. Suitable for long-term investors

Risks
Lower expected returns than the other asset classes Cash returns do not always keep up with inflation Returns are historically lower than equities Vulnerable to inflation and changes in interest rates Illiquid asset class Property bubbles can inflict large losses

Bonds

Property

Equities

More volatile than other asset classes Can suffer from market crashes

Diversification by blending asset classes

When building an optimal investment portfolio (portfolio construction), your financial adviser will often recommend investing in more than one asset class to diversify your portfolio and reduce risk. The percentage that you allocate to each asset class is based on your risk tolerance, investment timeframe and objectives. This is known as asset allocation. The aim is to balance risk and return by dividing assets between asset classes. An investor with a high tolerance for risk and a longer time horizon will typically invest in a more aggressive portfolio one that includes a higher component of equities, as illustrated below. Investors less comfortable with risk and with a shorter time horizon will typically opt for a more conservative asset allocation with a higher component invested in bonds and cash.

45+25+5 30+10+50 15+70+15

Example of asset allocation for a conservative investor Example of asset allocation for a moderate investor Example of asset allocation for an aggressive investor 45% bonds 25% cash 30% bonds 10% cash 15% bonds 0% cash 25% equities 5% property 50% equities 10% property 70% equities 15% property

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The process of portfolio construction

A well-constructed portfolio is devised with the help of a financial adviser who follows a consistent and thorough process. As a guide, this process would include: 1.  Identifying your goals. Your financial adviser will determine your individual financial situation and investment goals. He or she will consider your age, how much time you have to grow your investments, the amount of capital you wish to invest and your future income needs. 2.  Understanding your risk appetite. Your financial adviser will ensure that your risk and return objectives match your investment plan. Typically, a risk assessment will be carried out to determine your risk tolerance. 3.  Asset allocation. By understanding your current situation, future income needs and risk appetite, your financial adviser can determine how your investments should be allocated among different asset classes. 4.  Fine tuning your portfolio. If you have an existing investment portfolio, your financial adviser will review the asset allocation to ensure it is suited to you and will recommend changes, if any are required. 5.  Consistent monitoring. Once your portfolio is constructed, your financial adviser will continue to review your asset allocation on a regular basis. Changes in the economy, as well as personal life changes will dictate any changes required to your asset allocation.

Summary
Although you will use a financial adviser to construct your investment portfolio, it is important to understand how portfolio construction works and how it impacts you. Three things to note about the portfolio construction process: 1. Understand your risk appetite 2. Understand the importance of asset class diversification 3. Be consistent in monitoring your portfolio and making changes when required

Portfolio construction is an important aspect of building the right type of investment portfolio based on your long-term investment objectives. Speak to your financial adviser about the investment options available to you and how you can optimise your investment portfolio. To find out more about Discovery Invests award-winning investment range, or to find a Discovery Invest financial adviser visit www.discovery.co.za.

For more information on Discovery Invest, contact your financial adviser. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell investment funds.

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