Portfolio building: sectoral allocation risk-return

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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.

In the chart, the Industrials sector has the highest expected return and a middling volatility forecast – only a little more than the index itself. Industrials dominate all of those sectors that have higher forecast volatility (to the right of the black square) and lower forecast returns (below the black square). However, (Consumer) Staples, say, has a lower return but a much lower volatility. Therefore, Staples might be preferred to Industrials by more conservative investors and vice versa. Of course, it might be better to hold some of several sectors, if not some of each of all 11 sectors.

In my column on What not to buy: Part 2 – sectors, my reasoning was not about an expected volatility-returns trade-off; in that column I was taking into account the risks I perceived that weren’t covered by volatility forecasts alone – such as my opinion of the possible break in the way retail (consumer discretionary) will do business in the future with the adoption of internet practices.

The ASX 200 index, represented by the large black diamond in the chart, has close to an average expected volatility and return. The large red diamond to its left represents one possible portfolio from all of the sectors but in different proportions to those in the index. These differences in index weights are the so-called tilts.

This ‘optimised’ portfolio (using fairly complicated maths) has much the same expected return as the index but the expected volatility is lower. Of course other portfolios could have been constructed that have much higher expected returns by including more and more Industrials – but with more associated expected volatility. Discretionary, being of low expected return and moderately high-expected volatility, has no place in my own portfolio even without the internet.

So if we return to my own portfolio (which is not the red diamond), I hold no Discretionary, Staples, Property, IT nor Telcos. Clearly, I’m not a conservative investor. I am prepared to take the volatility swings and hold on for the long term, even through the GFC and the current sovereign debt crisis.

But this chart perhaps shows why I’m so overweight in Health. It has about the same expected return as the index but with a lot less expected volatility. Health and Utilities are my ‘counterweights’ to the riskier resource sectors, including mining services within Industrials. I very much use this type of analysis for my own super fund, but because I think I have the insights, I tweak the theory a bit along the way. To me, science is an excellent starting point and a great source of signalling new trends, but I never follow any method blindly.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

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