How to Build a Portfolio Kendal

Although we may not be the share- owning democracy envisaged by some of the more optimistic free-market disciples in the 1980s, many of us acquired shares from privatisations or, in the following decade, from building society demutualisations. Some of us might even still own them. Perhaps as an alternative to investing in collective funds and paying professionals to make investment decisions for us, those holdings – and any others picked up or inherited along the way – could form the basis of our own personally managed portfolios. Alternatively, maybe it’s not worth the time, effort or money.

There is no shortage of books telling us how to make stock selections and then, presumably, make us rich, but maybe we can learn from – and copy – some of the techniques used by those highly paid fund managers who run our OEICs, unit trusts and investment trusts.

They deploy widely practised methods founded on both academic teachings and on-the-job learning.

Fund managers normally have an investment philosophy – you can see it outlined on their websites – which will be broadly defined to include their “style” (for example value or growth), organisational structure and, most im-portantly for consultants who allo-cate institutional money, their investment process. The process is the precise mechanism whereby investment decisions are made.

For most balanced fund managers, it is a “top-down” approach: asset allocation follows an analysis of world macroeconomic factors, and includes country preferences, then sector choices, foreign exchange exposure and finally individual stock selection and the timing for market entry. All decisions are driven by asset class and market return forecasts. Of all the most important investment decisions, academic research demonstrates that asset allocation is by far the most important determinant of portfolio performance. Nevertheless, some highly successful fund mangers, notably Fidelity, use a bottom-up process, where the focus is simply on the merits of individual stocks regardless of asset class or sector, but which are then analysed within a broader context of the “big picture” or through scenario-testing.

Opinions vary about the amount of diversification a portfolio should have, but all agree that some is necessary. Modern Portfolio Theory (see box on page 19) suggests about 20-25 different shares, equally weighted, but Warren Buffet, for example, reckons 10-20 are optimal, calling too much diversification the “Noah’s Ark technique”, where “two of everything equals zero” performance. Peter Lynch’s huge Magellan.

Fund had to contain hundreds of different shares because he could not buy the ones he really wanted in sufficient quantities; he would have preferred a much smaller selection.

But the thinking behind diversification is sensible and prudent – don’t put all your eggs into one basket. The idea is to spread share-specific risk (or, in fund manager jargon, ‘alpha’), so that if one of your holdings performs badl...

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