When you are constructing a portfolio for a client, you’ll need to focus on two things: return and risk.

Suppose your client has a portfolio of mutual funds and you are considering adding another fund to the mix. The decision to add the fund hinges on this single question: what contribution will that additional fund make to the portfolio in terms of return and risk?

The return side is relatively straightforward. If the fund being added has a higher return than what the portfolio is already making, adding the fund should incrementally increase the portfolio’s overall return. In this sense, the new fund’s higher return should pull up the average return.

Alternatively, if the new fund has a lower return than the portfolio, it will act as a drag on performance. So, you wouldn’t add it to the portfolio — or would you?

Within the overall context of a portfolio, you have to look beyond return. Equally important is what, if any, incremental effect the new fund will have on the risk inherent in the portfolio. If the new fund can reduce the risk within the portfolio to a greater extent than it dampens return, it may be a good addition.

So, when adding or subtracting securities to a portfolio, you will need to understand what effect your decision will have on both return and risk.

> The Return Effect. The impact that a new inclusion has on a portfolio’s return is proportional to the weighting that the asset class or fund represents in the portfolio as a whole. This return effect is the same whether it is equities, fixed-income, cash or any other asset class. In technical terms, the portfolio’s return is simply a weighted average of the returns of the securities in the portfolio, in which the weights are the percentages each holding represents in the portfolio.

Suppose, for example, that a portfolio’s assets were 50% fixed-income securities and 50% equities. The fixed-income securities generate an 8% return; the equities, a 12% return. The portfolio, then, would have an overall return of 10%.

If we assume, for this exercise, that historical performance is repeated and if we increase the weighting of fixed-income securities to, say, 60%, the portfolio’s overall return would be 9.6%.

> The Risk Effect. The risk effect is more complicated. It relates to how much diversification effect a new inclusion offers. For example, fixed-income securities have a different sensitivity to various market forces than do equities — and equities respond differently to those forces than does cash.

For the most part, interest rates drive fixed-income values. Higher rates equal lower bond prices — and vice versa. Equities are also affected by interest rates, but to a much smaller degree. Equally important for equities are issuing company fundamentals, such as earnings growth, revenue, debt/equity ratio, etc.

A portfolio that holds both equities and fixed-income securities benefits from the diversification effect. The equities holdings insulate the portfolio somewhat from interest rate shocks, and bond holdings will shore up the portfolio in the event that corporate profits fall.

Cash holdings are relatively insensitive to changes in both profits and interest rates, so cash offers some diversification effect as well.

When the returns on different asset classes respond differently to the same influences, or respond to different influences altogether, that is when the diversification effect comes into play. If your client’s investments are spread over a number of different risks, no single factor will be able to take a large bite out of his or her portfolio.

Taking that concept to an optimal limit, you can diversify your client’s portfolio across such a wide array of risks that there will be no great exposure to any one factor. Under that scenario, the only way in which the portfolio could take a devastating hit would be if all of the risk factors ganged up on the portfolio at the same time. Short of the world coming to an end, that’s not likely to happen.

And if it does, your worries will be far greater than the worth of the portfolio.

> The Diversification Effect. Intuitively, diversification reduces risk. But what about the specifics?

In technical terms, the diversification effect occurs when the returns on different asset classes are not perfectly positively correlated. This means that returns move at different speeds and sometimes in different directions, because they respond differently to the same risk factors or respond to different risk factors altogether.

@page_break@We measure that through a correlation coefficient, which effectively indicates the relationship between two securities. A correlation coefficient can have a value between +1 and –1.

The former reflects perfect positive correlation — meaning that both securities move to the same degree at the same time, which, in turn, means no diversification effect whatsoever.

The latter indicates perfect negative correlation, in which two securities move in exactly the opposite direction by exactly the same degree all the time. If a portfolio consisted of two perfectly negatively correlated securities with both securities exhibiting positive long-term returns, the portfolio should produce a steady positive return with no risk — with risk defined as the variability of return.

But there is obviously no such thing as perfect negative correlation across assets with long-term positive returns. Hence, we attempt to build the diversification effect within a portfolio by searching for assets with correlations between +1 and –1.

And the closer the coefficient within the portfolio gets to –1, the more diversification effect within the portfolio. IE