Portfolio Construction Basics
What is SRI?
Socially Responsible Investing (SRI) refers to the practice of abstaining from certain investments on ethical grounds. SRI practitioners disregard the profit they could make from investing in companies with business practices that conflict with their ethical code. Socially responsible investors might refuse to invest in a company because of its products (e.g., cigarettes or alcohol), its management practices (e.g., covering up or failing to address abuse allegations), or its political affiliations.
How do I prepare for a recession?
Because it’s tough to predict exactly when a recession will start, investors should maintain a diversified portfolio at all times to limit losses during market downturns. The safest stocks to own during recessions are those of large, reliably profitable companies with ample cash flow and a track record of weathering turbulence. Companies in consumer staples, which include food, beverages, household goods, and toiletries, are also relatively safe bets during recessions because their products are basic necessities.
What is the relationship between risk and return?
Though the phrase may be “the greater the risk, the greater the reward,” high returns from risky investments are far from guaranteed. It may be more appropriate to say that the greater the risk, the greater the potential reward. Investing in an obscure upstart with a world-changing idea but no track record of success can pay off enormously if that company translates its idea into a viable business, but far more upstarts fail than go on to be the next Apple or Walmart.
What is an expense ratio?
The expense ratio is the percentage of a mutual fund or ETF’s assets under management that go toward paying the fund’s annual operating expenses, which includes the salary of the fund manager/advisor, recordkeeping fees, taxes, and accounting and auditing fees. These operating expenses reduce the amount of capital in the fund to be invested, which inevitably lowers the fund’s returns. Expense ratios have been trending down for decades. According to an Investment Company Institute report, the average expense ratio for index equity mutual funds fell from 0.27% in 1996 to 0.06% in 2021.
Risk tolerance is an imprecise measure of the amount of risk an investor is willing to accept. A highly risk tolerant investor might buy shares in a start-up that has taken on lots of debt to finance the development of a groundbreaking technology that could prove immensely profitable or go nowhere. Whereas a risk averse investor would stick to government bonds that come with small but guaranteed returns or the stock of a 100-year old company with a household name product that has little runway left for growth.
The 80-20 Rule, otherwise known as the Pareto Principle, is an aphorism that posits that 20% of inputs account for 80% of outputs. In the context of portfolio construction, the Pareto Principle holds that 80% of a stock portfolios returns in a ten year period can be attributed to just 20% of the portfolio’s holdings. The 80-20 rule is more of a general trend than a mathematical law and should not be assumed to be universally true.
Asset allocation refers to the ongoing process of allocating and reallocating money within an investment portfolio to different asset classes. The three main asset classes—equity, fixed-income, and cash and equivalents—all have different levels of risk and expected return. An investor’s risk tolerance and investment horizon help determine how much of their portfolio they apportion to each asset class.
Rebalancing refers to the periodic buying or selling of assets to restore one’s portfolio to a desired asset allocation. Because assets appreciate at different rates, a portfolio that’s 60% stocks and 40% bonds on January 1st could be 75% stocks and 25% bonds by the end of the year. Regular rebalancing keeps an investor’s portfolio aligned with their risk tolerance.
Investment objective refers to an investor’s broader financial goals beyond making more money. Possible investment objectives include saving for retirement, buying a house, or starting a business. An investor’s objective helps them and/or an advisor determine their risk tolerance, investment horizon, and optimal asset allocation.