Introduction. The Small Trades Portfolio Designer is programmed to create model portfolios for buy-and-hold and rebalancing strategies of investment 1, endnote. A draft design of trial portfolios enhances the use of the program. The drafting process begins with identifying the expected return or defining the market sectors of the portfolio. The purpose of this article is to describe the drafting process.
Expected-return method. The compound annual growth rate (CAGR) of historical returns is a suitable measure of expected return. Consider the following example: Assume the investor’s goal is to outperform the benchmark return of 5.68% defined by the market returns from U.S. large-cap stocks during 1997-2011. Table 1 lists market sectors (blue font, column 1) and market-sector CAGRs (blue font, column 2) obtained from the Small Trades Portfolio Designer. The market-sector CAGRs are inserted into equation 1 to calculate model CAGRs (white font, bottom row). The investor must assign weightings between 0 and 1.0 to the market-sector CAGRs [weighting factors of 0 exclude one market-sector CAGR and 1.0 exclude all but one market-sector CAGR from the allocation plan].
Model CAGR = aA + bB + cC + dD + eE + fF + gG + hH + iI,
Equation 1. Lower case letters a-i are weighting factors and upper case letters A-I are market-sector CAGRs.
Column headings #1-#5 represent trial model portfolios with model CAGRs that outperform the benchmark 5.68%. The cells in these columns, with exception of the bottom row, contain weighting factors (red font) from 5 different allocation plans designed by the investor. The assigned weighting factors must have a total value of 1.0 in every allocation plan and blank cells have a weighting factor of 0.
Table 1. The expected-return method of portfolio design.
Legend: The market sector CAGR (column 2) is computed by entering a 100% allocation weighting factor into the Small Trades Portfolio Designer. The model CAGR (bottom row) is calculated with equation 1 (see text).
Every trial portfolio in table 1 outperforms the benchmark return. In other words, every model CAGR (white font) exceeds the benchmark 5.68%. Trials #3-#5 offer the advantage of greater diversification among market sectors. Notice that every model CAGR falls within range of the market-sector CAGRs. Any model CAGR is always between -1.27% and 11.23% in this program based on the historical returns.
Market-sectors method. The second method is to test a fixed set of market sectors. Assume the investment goal is to outperform U.S. large-cap stocks with a model portfolio of 4 market sectors. Table 2 is a reconstruction of table 1 to illustrate trial models with a fixed set of market sectors.
Legend: Please see the legend for table 1.
In table 2, every trial portfolio outperforms the benchmark return for the simple reason that every market-sector CAGR (blue font) exceeds the benchmark 5.68%.
Risk. Table 2 illustrates the general notion that expected returns tend to increase with the risk of investment. For example, trial #1’s model portfolio has the highest expected return (10.68% CAGR) at the risk of having an overweighted sector in precious metals. A downturn in the precious metals market could have a devastating impact on the portfolio.
Market forces inevitably destroy an allocation plan by changing the market values, and therefore proportions, of portfolio holdings. The buy-and-hold portfolio becomes unbalanced and incurs the downside risk that a market decline will reduce the value of the portfolio. Two ways of managing the downside risk are to diversify and rebalance the portfolio holdings. Diversified holdings that have low correlations offer a better chance for compensating the declining sector with an advancing sector. Low correlations also signify an opportunity to gainfully employ the rebalancing strategy of portfolio management 2. The Small Trades Portfolio Designer contains a program to test rebalancing strategies on model portfolios.
Copyright © 2013 Douglas R. Knight
1. Jason Van Bergen, 6 Asset Allocation Strategies That Work, ©2013, Investopedia US, A Division of ValueClick, Inc., October 16, 2009.
2. William Bernstein, The Four Pillars of Investing: Lessons for Building a Winning Portfolio, McGraw-Hill, 2002.
The model portfolio contains hypothetical investments in two or more sectors of financial markets that earn an expected return.