How did you create your investment portfolio? Was it a carefully thought out, highly planned and disciplined process? Or was it what a new Vanguard research paper terms a “piecemeal” approach?
As our analysts write in the paper, Vanguard’s framework for constructing globally diversified portfolios: “Without a plan, investors often build their portfolios from the bottom up, focussing on investments piecemeal rather than on how the portfolio as a whole is serving the objective.”
Another way to characterise the piecemeal approach, the analysts add, is fund-collecting. “These investors evaluate a particular fund [or an individual asset] and, if it seems attractive, they buy it – often without thinking about how and where it may fit with the overall [portfolio].”
This plain-speaking research paper aimed at individual investors points to five major components for constructing and maintaining a sound, globally diversified portfolio in an orderly way:
- Define investment goals and constraints.
- Set your broad strategic asset allocation among the primary asset classes such as equities, fixed income and cash.
- Set your sub-asset allocation within classes such as domestic and non-domestic securities or large, mid or small-cap equities.
- Set an allocation to indexed or actively-managed funds or a combination of both.
- Arrange to regularly rebalance your portfolio to maintain a consistent risk profile.
Given the expectation of many investors for more subdued future returns, the creation of a portfolio in a methodical and disciplined way that carefully balances risks and returns is perhaps even more vital.
Returning to their warning about the “danger” of piecemeal portfolio construction without a plan, the analysts comment: “Although paying close attention to each investment may seem logical, this process can lead to an assemblage of holdings that doesn’t serve the investor’s ultimate needs.”
Further, the piecemeal approach may mean an investor ends up with a portfolio concentrated on a certain market sector or with so many holdings that managing the portfolio becomes an onerous task. In turn, such imbalanced portfolios can lead investors to make common yet avoidable mistakes such as performance chasing, market-timing (trying to pick the best time to buy or sell) or reacting to the prevailing market “noise”.
A sound investment portfolio can help an investor avoid such typically costly behaviour because it demonstrates the purpose and value of asset allocation, diversification and rebalancing. And it helps an investor to focus on contributing to their savings and controlling their spending.
In coming weeks, Smart Investing will more closely examine individual pointers, high