Efficiently Inefficient #5 : General principles of portfolio construction.

This books is really shaping up to be something that is good for novices and the experts.

Today I will talk about six very basic principles of portfolio construction. It is actually quite humbling that my own portfolio does not make the cut for all of these principles.

a) Diversification

The first principle is to diversify your portfolio. This is the only known free lunch in finance. This is best done across asset classes and industries. For folks like me who focus on dividend yields, it is much harder to conform to these principles. I normally look at REITs, business trusts and high yielding equity counters to get the job done. Ideally, you have to throw in annuities and some high yielding bonds into that mix.

b) Have position limits. 

You can have too much of a good thing. Always ensure that no matter how attractive an investment is, it should be limited to a reasonable proportion of your portfolio. 5% is a great number but for me this is more like 15%. This is not too straightforward if you only go for REIT yields because half the SGX would mean investing in only 20 REIT counters, so you have to look at other industries to keep your position limits low.

c) Make larger bets on high conviction trades.

At this stage, you have to deviate from the vanilla ETF strategies and look for high conviction investments and be willing to put more of money in it. Some folks are willing to do this if they like a particular story. For me, I like to use statistical tools to make my decision and generally speaking, the larger the yield, the larger stake I take.

d) Moderate your position by the risk of the underlying investment

The higher the risk of a position, the lower you size it. To balance (c) and (d), I try to reach for higher returns at a lower risk via my back-test, then I employ some leverage so that i can sacrifice a smaller part of my portfolio to take a larger stake in a margin account.

e) Correlations matter

This is violated by me because of the amount of number crunching involved. REITs are generally tied to real estate and move in tandem with real estate trends. Ideally you need to balance out your investments with other countries and industries but this is a mathematical exercise. Correlations also tend towards 1 in a very bearish market making this a very difficult exercise to do properly as a retail investor.

f) Resize positions dynamically.

Once you have all the five principles in action, you would need to react to resize your positions when the risk changes. The simplest expression of this principle is to rebalance your portfolio at regular intervals. This is also very hard to achieve for retail investors who may not have the time and discipline to make this happen.

At this stage, I can only say that I can apply these principles on a best-effort basis. This is something I need to keep in mind if the winds of changes were to affect my legal career.

If I go professional, these principals are possible the bare minimum that I have to adhere to before I start playing with other people's money.

Bonus : Read the Kelly Criterion from an earlier article or Wiki it to understand more about position sizing.