The Four Rules of Portfolio Management

How do we tactically build and manage portfolios to execute a long-term investment strategy? Investing in markets can be a long road, but our goal is to steer your portfolio in the right direction to help meet your long-term objectives. There will be times when staying with an appropriate, long-term investment strategy can be difficult—for example, when increased near- term volatility may be difficult to handle emotionally or when investors may be tempted to chase heat.

Our four basic rules of portfolio management can provide you with an investment compass. Remembering these four rules can help keep your long-term investment strategy aligned with your investment goals and objectives.

1.) Select a benchmark.

First, select an appropriate benchmark. An appropriate benchmark is necessary to measure relative risk and return and should be consistent with your time horizon and your required rate of return.

A benchmark provides a framework for your investment strategy to help construct a portfolio, manage risk and monitor performance.  A properly benchmarked portfolio provides a realistic guide for dealing with various market conditions. A strategic portfolio should be structured to maximize the likelihood of achieving goals. Simply aiming to achieve a fixed rate of return each year can cause disappointment when capital markets are very strong and greatly outperform your objective—and is potentially unrealistic when capital markets are very weak.

2.) Analyze the benchmark’s components and assign expected risk and return.

Once an appropriate benchmark is selected, each of the benchmark’s components is assigned expected risk and return. The objective here is to add value relative to the benchmark (although not necessarily in every period), while managing risk relative to the benchmark. Based on our outlook for capital markets, we determine risk and return expectations on benchmark components, which help us determine where the potential opportunities and pitfalls are.  Anticipation of market conditions in specific sectors and countries allows us to weigh them accordingly in portfolio construction.

3.) Blend dissimilar securities to moderate portfolio risk relative to expected return.

The next step is to blend dissimilar securities to balance risk relative to expected return. The basic principle is to overweight benchmark components (countries, sectors, size, style) we believe are likely to outperform the benchmark and underweight components we believe are likely to underperform. We believe making these calculated decisions increases the likelihood we can add value relative to a benchmark over time.

Additionally, building a counter investment strategy into the portfolio is essential in case the core investment strategy delivers less than anticipated. To moderate that risk, we blend securities with low correlations and hold them in underweight positions relative to the benchmark. For example, if technology stocks are expected to outperform, we may also hold some stocks that tend to zig (like pharmaceuticals) when technology stocks zag to offset relative risk if tech underperforms.

4.) Always remember we could be wrong, so we don’t veer from the first three rules.

Overconfidence is a dangerous trait in portfolio management and in choosing alternative investment strategies. It can sway investors to divert from sound investment objectives and assume sub-optimal levels of risk such as options trading or other alternative investment strategy. That’s why we always remember we could be wrong, so we maintain our investment discipline and don’t forget the first three investment strategy rules.