As both investment markets and our recommended funds have been volatile lately, we thought it would be useful to describe how portfolios are built and how they perform.

The following only scratches the surface, but covers the decisions which drive the majority of returns.

Asset Allocation

Asset allocation is what you invest in and where. The split between growth assets like shares and defensive assets like cash or bonds is the most important decision.

In the investment world, risk = returns. More specifically, risk = long-term returns. While including more shares in your portfolio increases the average return, the value will also fluctuate much more. After all, in any given year, shares typically do be better than cash about 60 - 70% of the time. Over time the odds improve; the charts below show the frequency shares outperform cash in four different markets, over 1-year, 5-year and 10-year periods.

We can see the trade-off between risk and return below. There are five hypothetical portfolios, each split between cash (S&P/NZX 90-Day Bank Bill Index) and NZ shares (S&P/NZX 50 Index). The more shares, the higher the return but the bigger the drops.

The countries you invest in make a large difference in short-term returns. For example, from 1997 - 2000, a poor manager buying US shares would probably earn you more money than a good manager buying NZ shares. For the following 3 years, the poor manager in NZ would do better! This is why we must evaluate each manager against the relevant benchmark. Below is a chart showing performance of NZ, US, Australian, European and UK shares respectively.

Investment Strategy

Once we have decided on what and where, next is how. Within each market, how do we pick the companies themselves?

You could choose an active manager, who claims to pick the best companies and avoid the worst, while charging a fortune for the service. However, research by Standard and Poors shows how these managers have done poorly for their clients. Below is the percentage of managers who underperformed the markets they trade in.

Another option is index funds, a cheap way to invest in the markets where active managers have failed. This is clearly (as shown above) a better option, but we can do better. In standard index funds, companies are arranged and purchased based on their size. But we can rearrange how capital is invested to tilt towards areas of higher returns without resorting to stock-picking or limiting diversification. We tilt towards dimensions of higher expected returns.

We mentioned how shares don't always outperform cash. The same applies to these dimensions; small companies don't outperform large companies each year, but the odds increase over time. The charts below show the frequency with which small companies outperform and, below that, value companies.

Like shares, there are times when these "premiums" are negative. Long-term, the results speak for themselves.