Most retail investors could often be very curious and concerned about questions such as what stocks should they buy, how do I identify undervalued stocks etc. Loads of times have been spent on the discovery portion in this case. And sometimes, the time spent could even be excessive.
However, what most do not realised is that understanding how to allocate and balance your portfolio could often be as important as understanding what stocks should you be buying. This is an art which most almost forgotten. You could be buying the most undervalued stocks in the world, but you might not be optimising your returns or taking far too much risk for your expected returns if you do not learn to allocate and balance your portfolio in an efficient manner. This is akin to a warrior having the best sword in the world but do not have any idea how to best manoeuvre it.
How do you then understand what's the best way to allocate and balance your portfolio in this case? Well, there are several steps you could undertake.
At the most basic level, you would want to first understand the correlations of the various asset classes in your portfolio to ensure that your portfolio is well-balanced. For instance, you probably do not want to have a portfolio whereby the individual asset classes are all highly positively correlated to each other. This would result in your portfolio performing badly in certain economic conditions as all of them could have the same reaction. For instance, having a portfolio comprising of only US equities and emerging market equities could be a terrible idea as the portfolio would likely do badly in unfavourable economic conditions as they are too positively correlated and would both be having negative returns in this situation. Hence, it is important to have a portfolio whereby your asset classes are not too positively correlated or even negatively correlated to each other to ensure it is well balanced (eg. a portfolio comprising of US equities, treasury bonds and commodities could possibly be a good combination).
The next important thing you could then need to do is to understand what's the best way to allocate the weightage of your portfolio to the individual asset classes to provide you the best form of return for the amount of risk you are willing to take. To do this, you have to first understand the concept of Efficient Frontier. Efficient Frontier is a portfolio selection model whereby several securities combinations are made to illustrate what's the best expected return for any given level of risk. Below is how it looks like.
(Source: Wikipedia)
You have the expected return on the y-axis and the standard deviation (which represents risk) on the x-axis. The hyperbola here represented the Efficient Frontier. Various combinations of asset classes could be represented as points on this graph. Points which are on the hyperbola (Efficient Frontier) represent optimal combinations of asset classes which provide the maximum amount of return for any given level of risk (standard deviation). Points which do not fall on the hyperbola (Efficient Frontier) represent inferior combinations of asset classes which either provide the same return but expose you to more risk, or provide poorer returns for the same amount of risk as compared to the combination of asset classes represented by points on the hyperbola.
In this graph, you could then also plot Capital Allocation Line (CAL) which is a line created to represent the various combinations of risk-free (usually based on current interest rate of US three month treasury bill) and risky assets (in this case, your portfolio). This line allows you to better understand the reward to variability ratio, or rather the Sharpe Ratio. The point which the CAL then intercepts the Efficient Frontier will then be called the Tangency Portfolio. This is the point where your portfolio is the most efficient with the most optimal combination of asset classes providing you with the maximised expected return for a given risk level, with the risk-free rate of return accounted for. This is then likely the balance in your portfolio which you would like to strive for.
Thankfully, there are tools provided for you to understand how the allocation of your portfolio should be to achieve the "Tangency Portfolio" so you do not necessarily have to code anything from the beginning. Here is one of such tools by Portfolio Visualizer. You simply just need to fill in your choice of asset classes (or tickers) into the tool with your current allocation and the results returned by the tool could then point you towards the optimal allocation as dictated by "Tangency Portfolio". I'm amazed by the level of details provided by this tool as it even provide you with information such as Expected Returns, Expected Volatility and the Sharpe Ratio for both your chosen allocation and the "Tangency Portfolio" based on the given duration you specified. This is certainly a tool I would encourage you to use when determining how much of your funds should be allocated to any single asset class or equity in your portfolio.
More articles on the topic of portfolio allocation will be released in the near future.
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