Portfolio Construction

We have finished all the premises and we can get to the point. Today we will see how a portfolio is built.

For macroeconomic portfolio construction, there are 2 main lines of thought for doing this.

  • Top-down: built following macroeconomic-driven forecasts (real economy, socio-political trends, population growth and aging, monetary & fiscal policies)
  • Bottom-up: based on microeconomic-driven factors (Qualitative filtering, & Quantitative filtering – Valuation or Technical analysis)

Below you can see the 2 strategies. Of course they can be combined together to understand which are the best companies to invest in.

Top-down                                                Bottom-up

Remember this

  • The top-down method enables you to manage the risk of your portfolio: When you fear markets will tumble, you may increase cash and / or hedge your market exposure.
  • The bottom-up approach only allows you to manage your portfolio risk if: You do not need to be fully invested You can do short selling

We will now look at various investment styles that can be used for portfolio construction.

Value vs Growth

“Value” stocks are “cheap” in terms of their price, relative to their: Earnings (E), Cash flows (C), Dividends (D) or Book value (B). “Growth” stocks are “expensive” in terms of these same valuation metrics.

Fama and French: “Value versus Growth: The international Evidence” (Journal of Finance, 1998) was a really important research because it showed really important data through their study. The objective was the study of the performances of value and growth stocks in 13 countries over the 1975–95 period.

The results were that Value outperforms Growth over the 1975-95 sample in 12 out of 13 major markets. Above all by an impressive 7.6% per year.

If you look closely at the chart below you will see that the MSCI world follows the value index much more than the growth index, but since 2010 it has misaligned a bit. Symptom that, probably with the extremely low rates, the growth department has grown the most.

Always remember that value can also be companies that have problems, there are various reasons why low growth is expected. Likewise, a growth company is more likely to be overvalued.

Momentum vs Contrarian

Very interesting portfolio construction dualism.

  • Contrarian investing is about looking for assets which are momentarily out-of-favor or they are not trading up to a price reflecting their value potential. A good point is that a contrarian can reversing a downtrend, allowing him / her di lei “buy the dip”. He or she needs a lot of money to keep the loss.
  • Momentum investing is about looking for assets which are popular and “hot” and have been recently delivering solid and rapid gains. They are reversing a downtrend which leads investors to “jump on the band wagon”.

Warren Buffet is a contrarian investor. His motto is famous: “Be greedy when others are fearful; be fearful when others are greedy”.

On the markets Contrarian investing has a stabilizing effect on markets, while momentum strategies may lead to price exaggeration (through herd behavior) and higher price volatility.

In my opinion, it is better to be a contrarian investor, because it brings a lot of satisfaction.

What is certain is that you could lose some of the gains that a bull market can give you.

Core & satellite

Now let’s move on not to market visions, but to portfolio building visions. As the name implies, it combines a “core”, where there are index funds (i.e. funds that seek to replicate the performance of an index) with the “satellite (s)”. This could be actively managed funds, for the less efficient asset classes where opportunities for outperforming an index are more common. In the example below not all cores and satellites in a portfolio need to be taken.

Portfolio Construction
Portfolio Construction
  • Pros: Lower fees: index funds (i.e. index trackers) charge very low fees compared to actively managed funds. Improved diversification due to the presence of actively managed funds. They should help reduce the correlation in the returns of the different asset classes in the portfolio.

Bonus link:

  • Backtest by Curvo: I spend 2 words on this site because it is really powerful in my opinion. You can create your own portfolio or start from those of the site and do as the name of the backtest site says. Also you can see Drawdown, Maximum loss, Efficient frontier, some Forecasts, Rebalancing strategies and Correlation of your portfolio and compare it with others. All for free.

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