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Building A Muscular Portfolio

Any investor worth his salt spends as much time thinking about portfolio construction as he does about security selection. Unsurprisingly, portfolio construction and its cousin, asset allocation, feature prominently in much of modern finance theory. At the simplest level, portfolio construction relies on understanding (a) the expected returns of various assets; (b) expected risk of the assets, generally defined as their volatility, and (c) expected correlation between the assets. Proper diversification - holding a variety of assets that have uncorrelated returns - is a central tenet of modern portfolio theory, since it allows investors to dampen volatility without necessarily compromising returns.

Some investors try to quantify these variables, leaning on historical performance, in order to maximize return and minimize volatility. Other investors, chary of relying on the past to formulate precise views of the future, prefer a more intuitive approach. As of this writing, I find myself tending towards the "intuitive" camp. I do think it's helpful to understand the historical volatility and correlation of assets in one's portfolio, which puts me at odds with those who argue that risk is not measured by volatility, but by the possibility of permanent loss of capital. Volatility does matter, for a variety of reasons. First, some asset owners cannot afford volatility, if they are relying on income or capital gains from the portfolio for their spending needs. Second, volatility, even if transient, can prove intolerable, and lead an investor to turn a temporary loss into a permanent one. It's far better to make allowances for this in advance. As I've written in the past, if you want profit, prepare for loss - and understanding volatility can be helpful in that regard.

Still, I recognize the limits of quantitative measures like historical performance, and have been toying with several metaphors to think about portfolio design. Inspired by Todd Hargrove's book on good physical movement, I have started to think of the well-constructed portfolio as a body moving skillfully and harmoniously. If I had to summarize this metaphor, it would preach diversification within limits, and being honest about one's risk and return objectives. Allow me to explain, with some ideas from Hargrove's book in italics.

All good movement is necessarily an act of coordination, which is defined as "harmonious interaction." The different muscles and joints cooperate as a team to create a particular outcome. The mechanical stress of movement should be shared by many joints, as opposed to highly concentrated in one joint.

First, in line with mainstream financial theory, the well-designed portfolio enjoys sufficient diversification. Over-exposure to any single asset or factor can have devastating effects on the portfolio whether or not you believe the performance is permanent. At the minimum, investors should be paying attention to concentration in terms of industry, geography, and currency.

Moshe Feldenkrais: One of the most important criteria for good movement is the ability to move in any direction at any time with a minimum of preparation. Great movers have their joints in neutral as often as possible, preserving a full array of powerful movement options at any time.

Good movement is not just about harmonious interaction or coordination between the different parts of the body. It is most fundamentally about how the system interacts with the environment, particularly in response to unexpected changes. Good movement implies a quality of adaptability and responsiveness to a changing environment.

Good movement is efficient. We can think of great movement as offering the most benefit in terms of achieving functional objectives, at the least cost to the body in terms of energy or physical stress.

Like good movement, the well-designed portfolio is robust to a variety of economic and financial shocks. If your portfolio depends on the Fed not raising rates in 2016, you probably have the wrong portfolio. In fact, if your portfolio depends on central banks never making mistakes, you probably have the wrong portfolio. The world is complex and unpredictable, and the well-designed portfolio is one that allows investors to sleep at night. Some think of an "efficient" portfolio as one that best manages the trade-off between risk and return, but it is equally valid to think of "efficient" movement, where the portfolio achieves its objectives at the least cost to the investor in terms of energy or physical stress.

Flexibility involves some minimum range of motion, but it is probably over-rated. Mobility is more important. Mobility is the degree of functional control over the end range of motion. Great movement is not about how large your range of motion is, it's what you do with the range you have.

Powerful movement should be generated from the core. The importance of the pelvis for power generation is easy to miss when watching great athletes or dancers, because our attention tends to be drawn to the periphery of the body, where skillful and intricate gestures are made at high speed. But these movements originate in the center.

Diversification is important, but it has its limits. At some point, the investor has to consider how much he can conceivably know about more assets. This isn't a problem if you're happy to rely solely on historical performance - you can reduce variables to a simple and tractable set of statistics. But if you want to have a qualitative view on the expected risk and return of an asset, you quickly bump up against constraints on how many such assets you can own.

In a similar vein, it's easy to get distracted by glamorous new assets. Hedge funds! Private equity! Venture capital! Everyone wants to be a sophisticated investor, but many are misled into believing that these glitzy new asset classes either offer something different to the portfolio, or are worth the financial cost and complexity. Consider me very, very skeptical on that front. You know how ridiculous it is when real estate brokers try to rebrand neighbourhoods with hot new names? Finance isn't much different.

Biomechanics aren't everything. Some people with significant chronic pain appear to have excellent movement patterns, and many people with seemingly awkward movement have no pain at all. In addition, movements and postures that are most efficient for one person might not work at all for someone else.

An athlete's ability to feel and maintain the unique rhythm of their particular body is an important determinant of the quality of their movement.

People have different return targets and different risk preferences. I've seen some investors who didn't bat an eyelid at being 30-40% down. I've seen others tear their hair out at 10% corrections. As the oracle at Delphi would have said, "Know thyself!" (If you manage money for others, perhaps this should be updated to "Know thyself, and thy investor base!") This is easier said than done, and it's far better to make small, incremental moves so that you aren't caught unaware by your own reaction when markets move sharply.

Like good movement, skilled portfolio management requires work, and realistically, mistakes. But there's no question that it's worth the effort, if you want to spare yourself a world of psychological and financial hurt.

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