Know yourself, know your portfolio

mats-hansson-218x158Savvy investment requires a lot of know-how and hard work. That's not the whole truth, however. You can become a better investor by knowing yourself better and by having a good holistic view of your portfolio. 

Investors who set clear investment targets for themselves and stick to them have the chance to build a portfolio that generates a return without any hassle or additional expenses. 

The situation is different if your portfolio and investment decisions are not firmly anchored to your goals and risk limits. In such a scenario, your investments will lack clear consistency and direction and you will commit errors in timing, which on average cost private investors thousands of euros that they should not lose.

It is easier to set return targets and risk limits once you begin to view your portfolio as an integrated whole instead of a collection of individual investments.

See the forest for the trees

All investors diversify their portfolios to a certain extent. There are so many investment alternatives available that hardly anyone can be so sure of the superiority of a single equity, for example, so as to invest all their money in it. Many investors, however, feel that even a well-diversified portfolio contains too much risk, so they add fixed income investments to their portfolios until they reach a suitable level of risk. 

Most investors are able to list all the holdings in their portfolios and more or less their current value. But if you ask them about their portfolios' expected return or long-term risk, few will be able to give you an answer. 

Seeing the forest for the trees, or seeing your portfolio as an integrated whole, however, is the key to investment.

The gentle art of knowing yourself

For many people, estimating their own risk tolerance is the most difficult aspect in investing. You need to know yourself – and by this we mean knowing yourself as an investor. You also need to know your investments and the markets because an investor must know how he or she will react in the world of risk and reward.

 If you don't know yourself as an investor, you can never be prepared for a decline in prices. What should I do if the market experiences a sharp drop – or should I do anything at all? If you've never considered these questions, you will end up with a lot of ill-timed purchases and sales. 

According to studies conducted by Ilia Dichev, Geoffrey Friesen and Travis Sapp in 2007, poor timing costs private investors an average of 1.5% a year in lost returns. If we were to assume that a portfolio worth 100,000 euros generates an annual return of 7%, poor timing would reduce its return over 20 years by close to 100,000 euros. 

Investors are realists

Investors should have a realistic approach because there's no sense in setting unachievable return targets. 

An investor should be able to reliably estimate risk, or in other words, the extent to which the actual return may differ from the expected return. Estimating your own risk tolerance is sensible only if you use it as a basis for building a portfolio that is in line with the risk estimate you make. 

In order to do this, you need an estimate of the portfolio's expected risk and return. How well can we forecast the risk and return of different portfolios? Eugene Fama and Robert Shiller, recipients of the Nobel Prize in Economics in 2013, approach this question from slightly differing angles. According to Fama, prices cannot be predicted in the short term, while Shiller argues that predictability improves over the long term. 

If your investment horizon is sufficiently long, you can join Shiller's camp. In order to get a grasp of your portfolio's expected return, it must be sufficiently diversified. The reason is that, of the entire risk involved in an equity, about 70% on average is company-specific, with the rest consisting of market and sector risks. Equity-specific and sector-specific risks are considerably lower in a well-diversified portfolio, leaving you to forecast only the market risk and return, which makes risk assessment a lot easier.

Since companies and their operating environments change very rapidly, the company-specific risk is difficult to handle in the long term. That is why it is difficult to estimate the risk and return of a portfolio with too much company-specific risk. As you can see, knowing whether the risk in your portfolio is at an appropriate level is not the easiest thing in the world.

Something new, something old

For many investors, knowing your portfolio's risk and return properties and being able to adjust the portfolio in line with your own risk tolerance and return target may be a new way of looking at investing. This doesn't mean, however, that you have to start all over again with your portfolio, but it does mean you have to make sure it is diversified enough for your risk and return estimates to be reliable. In any case, diversification is never a bad thing, so that's another benefit you gain from this new approach.

Mats Hansson
Asset Allocation Team Leader at Nordea Wealth Management