Like many analysts, I determine my portfolio weightings by my forecast of the risk-return trade-off – among other things!
I gave you a rundown of my sector weightings in Part 1 of my sectoral allocations series, when I focused on why an investor might not want to simply follow an index, like the ASX 200. Today, I’ll explain how I determine risk and return.
The essence of the argument is that an investor needs to be compensated for taking on extra risk by expecting an extra return. Forecasts of risk and return change over time, and sometimes sharply. Therefore, an investor needs to ‘rebalance’ a portfolio from time to time, which is something I’ll write more about in the New Year.
The mean-variance approach to risk-return – for which Harry Markowitz was awarded the Nobel Prize in Economic Science in 1990 – balances the expected return against expected volatility for each asset (in my case, my assets are the sectors of the ASX 200). One thing to note straight away is there is more to risk than volatility, but often volatility is about the only thing we have got to work with.
I show my forecasts in the chart below – more details can be found on my website, particularly in my Woodhall Quant Quarterly publication. Obviously, if these forecasts are of poor quality, any analysis based on them will be of little use. However, if the relative returns forecasts turn out to be wrong by about the same amount, that type of error is likely to be less serious than if the relativities of the sectoral forecasts are very wrong. The same goes for expected volatilities.