Build A Stronger Portfolio In Two Simple Steps

Build A Stronger Portfolio In Two Simple Steps
Stéphane Renevier, CFA

over 1 year ago5 mins

  • When deciding how much money to allocate to each investment, consider their “octane” levels. The higher the octane, the less you’ll need to make a portfolio impact.

  • To make your portfolio more robust, consider a higher weighting in assets that provide diversification benefits.

  • And consider using a “risk parity” optimization tool: it can show you how much money to allocate to each investment idea.

When deciding how much money to allocate to each investment, consider their “octane” levels. The higher the octane, the less you’ll need to make a portfolio impact.

To make your portfolio more robust, consider a higher weighting in assets that provide diversification benefits.

And consider using a “risk parity” optimization tool: it can show you how much money to allocate to each investment idea.

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A lot of investors spend tons of time thinking about what to put in their portfolio and then spend very little time thinking about how much money to allocate to each position. It’s a mistake, and can lead to unbalanced and unnecessarily risky portfolios. But by following two simple steps, you can avoid that mistake and build a more robust portfolio…

What are the two steps?

Step 1: Size up your assets based on their “octane” level.

Let’s say you’ve got an equally strong conviction about two assets – bitcoin and Coca-Cola, and you want your portfolio to be evenly weighted across those two things. Your first thought might be to split your portfolio 50/50. But these are two very different assets, and that won’t actually give you the mix you’re looking for.

See, bitcoin’s price is high octane: it tends to move a lot more than the lower-octane Coca-Cola’s. A useful (yet imperfect) way to quantify this is to compare the assets’ volatilities, which estimate how big the price swings are. Bitcoin’s annualized volatility is 81%, about four times more than Coca-Cola’s 16%. So if you were to buy $100 in each, you could expect your bitcoin investment to move – up or down – by $81 that year, and Coca-Cola by just $16.

Having a 50/50 allocation would imply that you have more conviction about bitcoin, because the outcome from whether you’re right or wrong on bitcoin will have a much larger impact than the outcome from Coca-Cola. In other words, your portfolio will be dominated by bitcoin, despite the fact that you initially allocated the same amount of money to both assets.

To remove this bias, and bring the contribution of each of your investments more in line, you need to allocate less to those “high octane” assets and more to the “low octane” ones. In our example, it means investing about four times more money in Coca-Cola than in bitcoin. That’s 17% in bitcoin, and 83% in Coca-Cola.

Step 2: Size up your assets based on their diversification benefits.

Now, let’s say you’ve got a portfolio of eight stocks and you’re considering adding gold and another stock. Assuming their volatilities are similar, you might be tempted to weight them evenly, allocating about 10% of your portfolio to each. But I wouldn’t: gold will bring a lot more diversification benefits to your current portfolio than another stock would. Your portfolio already consists entirely of stocks, after all, and stocks do tend to move in tandem with each other. Gold, on the other hand, is driven by different factors: it benefits when economic growth is weak and inflation is high, while stocks benefit when those conditions are reversed. So, you may want to dedicate more of your portfolio to gold and less to that ninth stock: it’ll add diversification benefits to your mix, likely performing well when your stocks struggle.

A useful (yet imperfect) way to quantify an asset’s diversification benefits is to look at how strongly it is correlated with other assets. Assets that move perfectly in tandem with one another have a correlation of 1, while assets that perfectly diversify each other have a correlation of -1. The lower the correlation of an asset to the rest of the portfolio, the more useful it is as a diversification tool and the more weight you should give to it.

So, how do you put this to work in your portfolio?

Let’s say you know that you want to hold eight stocks, some gold and some bitcoin in your portfolio. You can determine what allocations are best for you based on each asset’s octane and diversification benefits, using a method called “risk parity”. Essentially, this equalizes how much risk – and return – each asset brings to your portfolio. There are free optimization tools out there that can help you do this, like this one from portfoliovisualizer.com. All you have to do is select the assets you want to add, select “risk parity” as the optimization goal, and then “compare allocation to inverse-volatility weighted”. Finally, click “optimize” and, ta-da, you’ve got the allocation based on the two steps just explained.

Diversification, octane level and weight for each asset. Source: Portfoliovisualizer.com, FInimize
Diversification, octane level and weight for each asset. Source: Portfoliovisualizer.com, Finimize

As you can see, gold received a much higher weight than the other assets. That’s not just because it is the lowest-octane asset with a volatility of 14%, but also because it is the most diversifying one, with a correlation of zero to the other assets. By holding a higher weight in it, you’re making your portfolio a lot more robust. That’s also why defensive stocks like Walmart and Colgate-Palmolive received a higher weight than the high-octane Tesla or the highly cyclical General Motors. As for bitcoin, the main reason why you need to allocate only 3% is because it’s an extremely high-octane asset, with volatility that’s four times higher than your average stock. So you don’t need to hold as much to have a sizable impact in your portfolio.

These weights offer a recommendation: a suggestion of how much to allocate to each of your positions, assuming you don’t have a strong conviction on one asset over the others. If you do have a strong conviction for one, then allocate a bit more, but be careful about deviating too much from the original allocation since that can knock your portfolio out of balance. So, if you’re really bullish on bitcoin, for instance, I wouldn’t devote much more than 6% to it, or twice the suggested allocation. Conviction is important…but it’s more useful in determining what’s in your portfolio than in determining allocation amounts.

Creating a robust portfolio with the right allocation mix is more of an art than a science, and there are many methods out there – and sometimes one method even disagrees with another. The important thing is to find a starting point – a better way to think about your asset allocations – and experiment and perfect it as you go.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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