Portfolio Construction
12 articles
The decisions above any individual position: allocation, rebalancing, what to measure performance against, and the arithmetic of taking money back out.
Foundations
Start here if the subject is new.Asset Allocation
The split between asset classes is the decision that determines most of a portfolio's variability. It is also the one made least often and reviewed least carefully.
Rebalancing
Left alone, a portfolio drifts toward whatever has performed best. Rebalancing restores the intended weights, which means selling what has risen.
Dollar-Cost Averaging
Investing a fixed amount at regular intervals. It is two different things depending on whether it describes ongoing contributions or the deployment of a lump sum.
Horizon and Risk Tolerance
Two different constraints that are frequently treated as one. Horizon is a fact about when the money is needed; tolerance is a fact about what will actually be held through.
Intermediate
Assumes the foundations above.Choosing a Benchmark
A return means nothing on its own. What it is compared against determines whether it was good, and the comparison is frequently chosen to flatter.
Tracking Error
How far a portfolio's returns deviate from its benchmark, measured as a standard deviation. It quantifies how different a portfolio is, not how good.
Sharpe, Sortino and Risk-Adjusted Return
Return per unit of risk, where risk means the variability of returns. The measures are useful, widely quoted, and rest on assumptions that returns do not satisfy.
Home Bias
Investors everywhere hold far more of their own country's market than its share of the world would suggest. The pattern is universal, well documented, and only partly rational.
Concentration and Diversification
Diversification lowers the variability of an outcome and lowers the extremes in both directions. Which is preferable is a question about objectives rather than about markets.
Advanced
Detail, edge cases and methodology.The Efficient Frontier
The set of portfolios offering the highest expected return for each level of risk. A foundational idea, and one whose inputs are estimates with enough error to move the answer entirely.
Performance Attribution
Decomposing a return into the decisions that produced it. Without it, a good year and a lucky year look identical.
Taking Money Out
Drawing down a portfolio is a different problem from building one, because the order of returns starts to matter. The same average return can produce very different outcomes.
Frequently Asked Questions
What is asset allocation?
Asset allocation is how a portfolio is divided among broad categories such as stocks, bonds and cash. It is the decision above any individual holding, and it largely sets how much the portfolio's value swings, because assets in the same category tend to move together and assets in different ones often do not.
Read the full article: Asset AllocationWhat is rebalancing?
Rebalancing is trading a portfolio back to its target weights after market moves have pushed it away from them, for example selling some of what has grown and buying what has lagged. It keeps the portfolio's risk where it was set, and it can be done on a calendar or whenever a weight drifts past a threshold.
Read the full article: RebalancingWhat is the Sharpe ratio?
The Sharpe ratio is a portfolio's return above the risk-free rate, divided by the volatility of its returns. It measures how much return was earned per unit of risk taken, which makes two strategies with different volatility comparable. It treats upside and downside swings alike, which the Sortino ratio adjusts for.
Read the full article: Sharpe, Sortino and Risk-Adjusted Return