Successful portfolios start with realistic expectations

Establishing realistic objectives and managing investment biases are key elements of constructing effective portfolios, says Susan Spence, vice-president of Portfolio Solutions Group (PSG).

Spence, a portfolio manager with PSG, a division of Canada Life Investment Management Ltd., said objectivity is critical when assessing investments and creating portfolios that meet client expectations.

“Investors may have style, regional or asset-class biases that prevent them from achieving effective diversification within a portfolio, potentially creating an unnecessary headwind in their journey toward achieving their financial goals,” she said.

Recency bias — a fixation on areas of the capital markets that are currently doing well — is a particularly common pitfall that leads investors to chase short-term performance.

“This behaviour can result in an unintentional increase in the risk profile of a portfolio,” she said. “Establishing a disciplined approach to portfolio construction and overall portfolio management — and sticking to that discipline — helps to manage investor biases.”

Spence described diversification as one of three principles of portfolio construction, along with targeting consistent delivery and managing risk.

She constructs portfolios in layers, establishing a broad asset mix as a baseline for long-term risk-and-return objectives. From there, investors should take a more granular approach within each asset class, using distinct “building blocks” that can act as offsets or positioning levers. The aim, she said, is to protect the portfolio in market downturns.

“Having exposure to investments with a variety of return drivers and risk profiles can help to insulate investors from the volatility of capital markets,” she said.

Finally, constructing effective portfolios relies on appropriate strategies for controlling risk.

“One example would be determining a suitable cap on illiquid exposure,” she said. “This can be achieved by stress-testing the liquid portion of the portfolio to understand the implications of market selloff on the relative size of illiquid holdings and determine a level of comfort around those allocations, keeping in mind the ongoing cash flow requirements of the portfolio.”

Spence said it is important to consider the risk-and-return characteristics of asset classes in combination, not just how they behave in isolation.

“A portfolio’s strategic asset mix should be driven by long-term trends in return and volatility for each asset class, as well as correlations across asset classes,” she said. “And return expectations should be checked to ensure that they reflect forward-looking views.”

As for bringing in new asset classes, a deciding factor should be whether their inclusion would add value on a risk-adjusted basis.

She cited direct exposure to real estate as an example of an asset class that can positively impact the risk-return profile of a standard portfolio.

“Over long time periods, real estate has low or negative correlations with both equities and fixed income. And, interestingly, this is in contrast to looking for exposure to real estate through an allocation to REITs,” she explained. “REITs have a very different risk return profile than direct real estate investments, and their performance is actually very highly correlated to equity returns.”

Successfully navigating the challenges of portfolio construction will pay dividends in the long run, Spence said.

“A well-constructed portfolio provides a framework for risk-and-return expectations over the long term, and helps to define the suitability of a portfolio for investors,” she said. “If investors are comfortable with the path that they follow over time, through changing market conditions, and are willing to stay invested, then they should be more successful in reaching those financial goals.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.