Steps to successful portfolio management (Part 1)

Ask any professional investor what the hardest part of portfolio management is and 99 per cent will answer: "Discipline". They must have the ability to stay the course in a set and proven methodology, since making investment decisions is by far the greatest challenge an investor faces. Why is this so difficult? Because as human beings, we are trained to look for trends that don't really exist, to judge long-term potential by short-term results and, in short, suffer from a belief that activity in a portfolio represents better performance.

Arguably, the world's best, and certainly the most well known investor is Mr. Warren Buffett. He is called the Oracle of Omaha since he constantly produces quotes on how to invest money. His best-known line is:

"To invest successfully over a lifetime does not require stratospheric IQ, unusual business insight, or inside information. What's needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework"

We can help you establish the steps in an intellectual framework to allow you to invest successfully over a lifetime.

Step One - Understand the End Game

If you had to drive your car across Canada from Ottawa to Victoria, what would be your first step? Most people would start by buying a map. In other words, you have to know where you are, where you are going and how to map out the best way to get there. Although this appears to be common sense, one of the main reasons people fail to stick to an investment is that they did not take the time to actually develop a plan. They invest to get the best return on their money. The problem with this approach is that it is quite open ended - like chasing the horizon. It is impossible to measure and therefore will lead to frustration.

We recommend that you create a roadmap, which is based on your risk tolerance, time horizons and ability to save, and establishes the rate of return you will need to average on your investment portfolio to achieve your long-term goals. This will be known as your Personal Investing Benchmark. Each time you review your portfolio, you won't compare it against some unattainable goal, but against what you need to achieve your dreams

Step Two - Portfolio Design

Is your current portfolio based on a proven methodology or just a collection of good ideas?

The goal of portfolio management is quite simple - to achieve the best return on your investment with the least amount of risk. In other words, making a good return is only one part of the equation; you also have to spend time understanding the risk associated with each investment decision that you make.

Successful portfolio design comes from understanding the right balance between:

• Asset allocation (equities, fixed income, and other asset classes)
• Geographic allocation (Canada, US, and international)
• Style allocation (value and growth)
• Market capitalization (small, mid and large capitalization)

You must then decide on the proper methodology to rebalance the portfolio. The two basic theories behind rebalancing are "strategic" and "tactical".

Strategic allocation occurs at the inception of the portfolio. Based on extensive studies of correlation of all of the above, a base policy blend is established, founded on expected returns and risk. Then the mixes are rebalanced to target weights according to the original mix, usually at regular intervals such as monthly or quarterly, to maintain a long-term goal for portfolio allocation.

The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework to create an additional source of return. An attempt is made to take advantage of short and intermediate term market inefficiencies as a means of managing investors' exposure to market risk.

You should decide which methodology is best suited to your long-term objectives and then have the discipline to stick to your chosen tactic over the full investment cycle of your portfolio.

Step Three - Investment Specialist Selection Process

It is one thing to establish a portfolio methodology, but now comes the hard part. How do you objectively choose the best investment specialist for each mandate in your portfolio?

In Canada alone, there are over 5,200 different investment specialists. On a worldwide basis, that number goes up exponentially. As Mr. Buffett states, you need an intellectual framework to limit your choices. We recommend that you follow a quantitative analysis and then a qualitative analysis methodology.

Quantitative Analysis - A quantitative analysis is really the process of elimination. You start with a mandate category (i.e., US equity large cap value) and begin to eliminate what you don't want such as sub par performance, no long-term track record, management changes, under capitalization, and many more factors. This will usually eliminate the 90 per cent of investment specialists.

Qualitative Analysis - Once you have your mandate list down to the top 10 per cent, start the detailed work. You should study dozens of criteria (risk ratios, Sharpe ratios, Alpha ratios, Beta ratios, underlying holdings, cost of investment, correlations to indexes, etc.) to limit yourself to the top 1 per cent in the category (usually five top players). The last step is to conduct what is called a Request For Proposal (RFP) with each of the candidates. This would be a 10 - 15 page questionnaire to obtain in-depth knowledge of each candidate. It may include personal interviews with managers, staff, and even other companies for whom they manage money. This data is presented to a committee of investment experts and a winner is selected.

This procedure is followed with every mandate in the overall portfolio. It may seem like a great deal of work, but professional money managers believe that the quality of the investment specialist makes all the difference to a portfolio in the long run.