Portfolio Theory

What drives portfolio returns?

• The stocks, bonds, or funds you pick?
• When you get into and out of the Market?
• The asset classes you choose?
• The amount of time you are in the market?
• The fees and other expenses you incur?

All of these are factors that impact your portfolio returns, but some are more impactful than others. So, let's list them in order of their impact.

#1 The Asset Classes You Choose

There have been several studies done by the eggheads in Academia and the Economics profession about asset classes. There is even a fancy name for it - Investment Policy. Why is this so important to portfolio performance? Because the investments that make up these classes tend to move together in price and return. If you allocate too heavily to an asset class that's out-of-favor, most of the individual stocks, bonds, or funds in the class will be dragged down with it. 

Let's say that you need a high rate of return to meet your objective on time, so naturally you'll gravitate to classes that have performed the best recently. You accept the increased risk because you need lots of horsepower. But when (not if) that class goes through a down cycle, your returns will suffer.

Which asset classes are the right ones for you?

• Stocks? 
• Bonds?
• Gold?
• Real Estate?
• Fine art?
• Bitcoin?
• Commodities?

Each of these classes has its own set of risk and return profile. Real Estate has been hot for the last 20 years. Does that mean it will remain hot for the next 10? No. 

Commodities have been in the doldrums for the last 20 years. Does that mean you should shun them? No.

My larger point is that you must be mindful of the cyclical nature of asset class returns, and build your portfolio in a way that doesn't leave you over-exposed or under-exposed to any one class.

#2 The strategy you put together

Once you decide how you'll allocate your money across asset classes, picking a strategy comes next. You can be active and aggressive with your trading, or you can be passive and let the market come to you. 

You can lean towards maximizing portfolio income, or go for capital gains. You can use a factor-based strategy or a sector rotation one. The choice is up to you. But the important part is not to mix too many different strategies together because inevitably, some of them will be at odds with others. Keep it as simple as you can.

Here's a list of strategies to choose from.

• Buy & Hold?
• Fast growth?
• Capital preservation?
• High income?
• Sector rotation?
• Factor-based investing?
• Beat the market (active, aggressive)?
• Match the market (passive, conservative)?

There are so many different strategies to choose from, it can become overwhelming. Again I say let simplicity rule. Pick 2 or 3 and stay with them long enough to find out if they work for you.

#3  Costs

Jack Bogle, founder of Vanguard Funds, was a champion for the cause of keeping costs to a minimum. And for good reason. Because costs are incurred on an ongoing basis, they compound just like your investment returns. 

A high-cost portfolio can take 50% or more of your final wealth by the time you're ready to start living off your investments. That's not an exaggeration. I ran the numbers myself many different ways and it's true. Watch your costs. Avoid annual advisor fees if possible. And make sure you have a competent tax advisor when it comes time to start selling.

In the coming lessons we'll drill down into the details to get some clarity