Investing can be a daunting task, be it a newbie or an experienced investor. This involves selecting different assets that gel well with each other and return a good profit. An extension of investing is creating and maintaining portfolios.
What makes a portfolio?
Creating a portfolio is the opposite of putting all your eggs in one basket. It involves, allocating your money in different assets with two main goals – preserve/increase the wealth and minimize risk.
This can be done via 3 methods
- Selecting different weights for assets included in the portfolio
- Finding a balance between minimizing risk and maximizing rewards
Together, points 1 and 2 have the same goal, which can be achieved by either changing the asset and/or varying the weight of the assets.
1. Weighting indices
Traditionally, investors have been told that a standard portfolio contains 60% of its holdings in equities and 40% in bonds. This was and to some degree even now, is considered the best way to invest that minimizes risk and yields a steady return.
The 60% which contains the equities usually includes the Standard & Poor’s 90, the Wilshire 5000 Index, the MSCI US Broad Market Index, and the CRSP US Total Market Index, etc.
This 60/40 portfolio referred to as a balanced portfolio has an average annual return of 8.6% over the last 93 years.
In fact, the portfolio combination with stocks and/or bonds has never yielded an average annual return of more than 10%. An exception was with a portfolio containing 100% of stocks; this had an average annual return of 10.1%.
While creating a portfolio, one has to take care of the weight given to different assets/indices. Based on this weightage, the investment is done, hence, it is necessary to select assets with a proper history of risk/reward, that suits the investor’s needs.
Popular assets included in a traditional portfolio include the S&P 500, Willshire 5000 Index, the CRSP US Total Market Index, the MSCI US Broad Market Index, the Lehman Brothers U.S. Long Credit AA Index, Citigroup High Grade Index, the Barclays Capital U.S. Aggregate Bond Index, the Barclays U.S. Aggregate Float Adjusted Bond Index, etc.
2. Finding the balance between minimizing risk and maximizing rewards
A good portfolio contains a mix of assets that yield good returns and simultaneously have low risk. Take, for example, the Sharpe ratio for the S&P 500 for the last 10-year show that it is 0.84. with a max drawdown of -20% and a standard deviation of 13.25.
According to Google, Sharpe Ratio measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. Hence, the higher the ratio better the asset’s reward compared to its risk.
Usually, a Sharpe ratio above 1 is considered good, but since S&P 500 is close to this value, its risk-to-return is much better than many assets, and hence used widely.
For the standard portfolio of 60/40, this can be done by changing the ratio of the assets – for example