In the previous article, we thoroughly discussed aspects of portfolio management such as questionnaires, investor profile, and investment strategy. The next step is crucial for successful investment, since asset allocation is a major determinant of investment results.

Asset Allocation

Once an investment strategy for a particular investor has been built and the investor has approved it, the following alternatives are possible:

  1. The investor themselves selects assets according to the investment strategy.
  2. The digital advisor offers the investor a number of asset-allocation models in accordance with the investment strategy and the investor’s preferences; the investor chooses one, which is then implemented by the system.
  3. The digital advisor offers the investor one asset-allocation model, which is implemented upon approval by the investor.

The first case is outside the scope of our topic, but the other two are worth looking at more carefully.

Recommendations on asset allocation are created by algorithms that may use various financial models, such as Modern Portfolio Theory, the Black–Litterman Model, the Fama–French Model, the Capital Asset Pricing Model, etc. Similar investment strategies may result in very different asset-allocation models.

An asset-allocation model created by an algorithm should conform with the following principles:

  • To protect the investor’s money against significant losses, the portfolio should be diversified—i.e., spread across a broad range of assets. This may help to neutralize market downs (assets with negative performance) with ups (assets with positive performance).
  • The portfolio should contain assets that are noncorrelated—i.e., have high performance over different time periods. This means that performance movements of one asset will not affect the performance of other assets.
  • Though an investor may prefer to invest in one type of company (e.g., companies of a particular size or working in a particular industry), such a portfolio may appear very risky under certain economic conditions. Combining stocks of various companies from a range of markets can significantly reduce the volatility of the portfolio returns.
  • Exchange-Traded Funds (ETFs) can be a viable alternative to stocks, since they may be perceived as mini-portfolios and offer a slightly diversified basket of stocks grouped by industry, market cap, etc.
  • A portfolio should not contain too many assets of each class. Overdiversification may result in an inability to monitor and efficiently rebalance a portfolio, and this will lead to its underperformance. Modern Portfolio Theory recognizes a 20-stock portfolio as optimally diversified.

When selecting an asset mix for an investor according to their investment strategy, the following steps should be followed:

  1. Identify the best assets within each asset class in the investment strategy. The potential return should be analyzed for each asset; those with high potential return are worth further consideration.
  2. Calculate the volatility of each asset and its sensitivity to various economic scenarios, such as stagnating or explosive growth. Assets that are less sensitive to economic movements may be recommended for a portfolio.
  3. Assess correlations across all assets. The different assets within one portfolio should perform differently in any period of time; otherwise, they may all have low performance under certain market conditions, causing significant portfolio losses. If the selected set of assets includes correlated assets, some of these should be removed.
  4. Evaluate portfolio performance across different market cycles. The total potential return of assets in a portfolio should be high under all market conditions.

Once asset allocation is complete, the investor should be given access to information about each investment—how its return is calculated, whether it is guaranteed, and how it may improve the performance of the entire portfolio.

Predefined Asset Allocation

Some financial advisory platforms offer investors predefined asset-allocation strategies. This may enable inexperienced investors to take their first steps into investing.

For example, Folio Investing has over 160 Ready-To-Go (RTG) folios to help its clients get started. The RTG folios are split up into groups so that investors can choose one according to their targets, preferences, investment strategy, or attitude to risk. For each folio, a set of investments with their weightings is defined, and expected performance is calculated.

FolioFN RTG folios

FolioFN RTG folios

AssetBuilder offers a number of predefined portfolios, provides asset allocations for each portfolio, and shows annualized returns for the last several years.

AssetBuilder portfolio

AssetBuilder portfolio

AssetBuilder portfolio

Motif Investing offers a predefined portfolio that is customized according to the investor’s goals and values. For example, if an investor prefers to invest in eco-friendly companies, Motif removes those that don’t align with that value.

Motif portfolio

Motif portfolio

Motif portfolio

Ongoing Monitoring and Reporting

Once assets have been selected and the investor has an established portfolio, the financial platform starts to monitor the portfolio’s performance and provide periodical rebalancing or adjustments. Market movements may result in changed proportions of asset classes in investors’ portfolios; some portions of portfolios may become too large, while others become extremely small.

To define changed asset weightings and to monitor the entire portfolio’s performance, financial platforms may provide reporting to help investors evaluate their progress toward their financial goals.

Reporting may include analysis of the following parameters:

  • Return
  • Risk
  • Asset allocation

Return analysis

For most investors, total return is the most suitable way to measure how successful their investment is. Total return may be expressed in different ways:

  • Cumulative returns are often used for short periods of time (less than a year). Cumulative returns may be expressed in percentage terms or as a change in monetary value.
    The Motley Fool uses the following chart to show the cumulative return provided by its flagship service, Stock Advisor:

    TheMotleyFool cumulative

  • Annualized returns show the change in percentage terms over a period of more than a year. Annualized returns take into account gains and losses of the portfolio.
  • Relative return shows the portfolio’s performance compared to a selected benchmark. The S&P 500 is a popular benchmark for large-cap stocks. Barclays Capital US indexes are often used as benchmarks for bonds.
    The Robo Report provides a chart that compares the performance of leading robo-advisors over the previous two years:

    Robos performance

  • After-tax returns may vary depending on the investor’s marginal tax rate, country or state of residence, and other factors. In some cases, high before-tax returns may show lower after-tax performance. Many platforms provide tax-loss harvesting services to increase investors’ after-tax returns.
    According to Betterment, the Tax Loss Harvesting+ service may increase returns by about 0.77% per year:

    Betterment after-tax return

Risk analysis

Risk analysis allows investors to obtain a broader picture of their investment progress. The higher the risk investors undertake, the higher the return they expect. To assess possible risks, the following methods may be used:

  • Monte-Carlo simulation, which generates possible outcomes of decisions or actions.
  • Sensitivity analysis, which determines how sensitive investments are to changes in market conditions.
  • Scenario analysis, which shows a range of outcomes from best to worst.

Risk is often measured according to the following parameters:

  • Standard deviation is a typical measurement of an investment’s volatility.
  • Alpha measures risk relative to a selected benchmark.
  • Beta measures risk relative to the whole market.
  • Sharpe ratio is used to calculate risk-adjusted return.
  • R-squared measures the correlation between a particular investment and its benchmark.

Asset-allocation analysis

Asset-allocation reports should help investors to see whether the composition of their portfolio has changed due to market movements. In some cases, changed weightings of each asset may lead to a less diversified portfolio and make the whole portfolio more risky.

The investor may wish to see the percentage shares of asset classes in the portfolio or sub-assets within a particular asset class.

Bottom Line

We have discussed the most important parts of investment portfolio management, such as investor profiling and the questionnaires this is based on; building an investment strategy and choosing an asset allocation, and performance measurement and analysis.

Portfolio management entails a complex strategy of balancing between objectives and constraints, risk and performance, opportunities and threats, strengths and weaknesses. Any decision may play a crucial role in the success of investments, which is why portfolio management should be based on deep research and analysis of the investor and market situation.


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