Some resolutions for you at this difficult time.
Resolution 1: Know how much money your portfolio could lose due to extreme market fluctuations.
Without knowing this, how can you tell if you have a portfolio whose potential losses you can stomach? Before online portfolio tools these used to be impossible things for the private investor to know.
By anticipating the potential losses your overall portfolio may typically incur, you can decide whether to rebalance your holdings.
For instance, imagine you hold £5000 each of a selection of UK companies in the FTSE 100 eg Aviva, Lloyds, Barclays etc.
You may think the worst-case loss would be roughly the same for each stock – they are all FTSE 100 stocks and you hold the same amount of each. Wrong.
You’re likely to lose four times more (around £600) with one of them on a bad day for that stock, than with another. That may be more than you are willing to accept: time to rejig the portfolio.
What about the average loss you can expect each month holding such a portfolio? Of course all the stocks within it would not have their worst losses on the same day. On the above portfolio, an extreme loss would be around £1,500.
Too much to lose? Swap stocks with high volatility and ‘beta’ and the worst-case average portfolio loss drops to £1,000. Depending on the stock swaps, you don’t necessarily reduce potential reward despite cutting risk.
Resolution 2: Don’t deny Nobel Prize winning research; understand how online tools can warn you about under-diversification.
In 1949 University of Chicago student Harry Markowitz discovered that portfolio performance was down to stock correlation (how much in lock-step stocks in your portfolio move with each other).
He discovered that adding volatile stocks to a portfolio actually decreased the portfolio’s overall volatility if the stocks were not highly correlated: you could increase returns for the same level of risk.
Are some the stocks you own simply mimicking the performance of others already in your portfolio giving the illusion of diversification but thereby latently increasing the risk of loss from a single event?
Similarly is the weighting of a few stocks swamping the effects of others making their inclusion redundant? Thanks to online portfolio tools traders can quickly answer these questions for their own portfolios.
The problem is, how many online traders when picking stocks bother to see how it will affect their existing portfolio?
Resolution 3: Remember it is all in the asset allocation. In 1986, a study* revealed that more than 90 per cent of a portfolio’s return has nothing to do with choosing the perfect stocks or when you buy and sell. Instead performance depends upon how the investments are divided among stocks, bonds and cash.
Consequently, it’s important to know your risk profile in order to decide how much of your portfolio should be invested in each asset class. Truthfully, how many online traders bother to do that?
Of course there is an alternative viewpoint to all this portfolio pondering. As with Markowitz’s advice, it too comes from a Nobel Prize winner, Paul Samuelson; “You shouldn’t spend much time on your investments. That will tempt you to up the plants and see how the roots are doing and that’s very bad for the roots.”
* "Determinants of Portfolio Performance," published in the Financial Analysts Journal (July-August 1986), Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower
