Interest in stock market movement has grown during the past decade. More individuals own shares as part of their portfolio than a decade ago. It is very important to understand the determinants of portfolio performance. Empirical investigation in investment science literature during the last couple of decades established that a portfolio’s performance is largely a function of different factors. The factors that majority investors think that are important for performance are in fact relatively inconsequential. Let us discuss some of the important determinants of your portfolio performance.
The first is investment policy, which sets your default allocation of investible funds to each of the major asset classes, such as equities, fixed income, gold, cash, and so forth. The key characteristics of an investment policy are its long-term focus and asset allocation strategies. Asset allocation is the process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes. An asset class is comprised of securities that have similar characteristics, attributes, risk-return relationships. A broad asset class, such as bonds, can further be divided into smaller asset classes, such as treasury bonds, corporate bonds, and high-yield bonds. In the long run, the highest compounded returns will most likely accrue to those investors with larger exposures to risky assets. The asset allocation decision is not an isolated choice; rather, it is a component of a portfolio management process.
The second major determinant in portfolio performance is market timing, which leads to deviations from the default allocations dictated by your own investment policy. Your investment policy might call for you to be fully invested in stocks, for example, but you also might believe that stocks are extremely overvalued right now and decide to be only 50% invested in equities. This deviation from policy is popularly known as market timing which is an important determinant in portfolio performance.
Asset classes have unique cycles. In some years, small and value stocks may outperform the market; in others they may underperform. It takes resilience and psychological preparedness to endure the times they underperform. Remember, investing in small and value stocks should augment the bottom line in the long run, but investors should understand that their portfolio will not identically track the market every single year.
The other major determinant of portfolio performance is security selection. Do the particular securities you own do better or worse than their asset class as a whole – this is an interesting question which always ringer at the back of the mind of each investor. For instance, on average, being fully invested in stocks was very profitable during the decade of the 1990s. But it would have been a lot less profitable if your entire stock portfolio was invested in only a few particularly poor-performing small-cap value stocks. This could have lowered the return which is attributable to share selection.
Capital markets do a good job of fairly pricing all available information and investor expectations about publicly traded securities.
Intense competition drives the market to near-efficiency though not complete efficiency. Securities prices are fair and reflect the best estimate of the company’s actual value. Efforts to identify undervalued stocks or markets are always rewarded in spite of fair pricing based on available information as there is always information asymmetry exists in capital markets across the globe.
Diversification is key
Comprehensive asset allocation can neutralize the risks specific to individual securities. It reduces the impact of individual securities and enables investors to scientifically employ the risk factors that offer higher expected returns.
Risk and return are related
The compensation for taking on increased levels of risk is the potential to earn greater returns. Only non-diversification risk is systematically rewarded over time. So, differences in the average returns of portfolios are due to differences in average risk. Multifactor investing brings a systematic approach to harnessing these risks to deliver above-market performance over time.
Portfolio structure explains performance
The asset classes that comprise a portfolio and the risk levels of those asset classes are responsible for most of the variability of portfolio returns. Asset allocation among other determinants accounts for most of the performance in a diversified investment strategy.
Deciding on the degree to which your portfolio should be based on the above factors is the challenge for the investor. Tilting towards small and value stocks will help you reach above global market returns, but portfolio risk must be tempered by adding other assets with low correlations.
The writer is associate professor finance & accounting, IIM Shillong