Portfolio Construction

Let’s hear your portfolio contruction methodologies.

i hold cash when i have no ideas…when i find a stock i buy limiting the exposure to a max of 20% to the overall portfolio…no security should be more than 20% but if it is due to other stocks having gone down, i don’t care…i stick with it or buy more of the down stock to rebalance…

I risk-weight my portfolio. Position sizes are inversely related to asset volatility (which I agree is not the only measure of risk, but it is still a relevant one). I first encountered this idea in the turtle trading methodology but have adopted it in a kind of modified MPT framework. Risk weighting is an increasingly popular method, and has been discussed in a number of threads here.

I could optimize using correlations, but since correlations are unstable and require substantially more calculations, I often just use the raw volatility and forget about correlation. Tail risk really ought to be managed separately from ordinary risk anyway. I like this method because it means that my “skill” is evenly likely to produce benefits across the assets in the portfolio, and it is a lot simpler than calling up an optimizer every time you have a new investment idea.

I’ve thought about things like having a target forward-looking volatility and a minimum cash allocation, but quite honestly there’s just been other stuff on my plate.

I agree with Frank that it is important to be willing to hold cash (or, alternately, the benchmark) when you have no ideas; however, some investment strategies don’t permit this, particularly if you are managing other peoples’ money.

bchad…if you’re a mutual fund than yes, its not possible to be in cash in a significant way…but its not true if you’re managing private assets…we have been doing fine staying put in cash until the time comes…

what i don’t understand with your strategy is (I am assuming you’re not a public fund manager where your performance is public) is why all this correlation and volatility actually matters. all that stuff is really just market driven and not intrinsic risk…

sounds like it matters to you if the asset falls by half or whatever…but why?

I am one of those CFA types who believes 90% of return is driven by optimal asset allocation while 10% is pure luck.

I’ve balanced my own allocations by throwing darts. I don’t have any real methodology or construction rules to follow.

Frank, if you are investing other peoples’ money and are charging fees on it, people get upset if you charge them 1% just to hold their stuff in cash. They may thank you later if you’ve avoided a crash, but if the market is going up and you’re in cash, they won’t understand (and to avoid a crash, you usually have to be in cash at the final stages of an uptrending market). So unless you are very explicit up front that you will sometimes have substantial cash allocations, it can be an issue.

I agree if you can get away with large cash allocations, it is often good to take advantage of it.

I care about the asset dropping by 50% because if it drops by 50%, I then need 100% gain just to get back to even. 50% losses happen more often than 100% gains (at least within similar time-frames), so if you can avoid those 50% drops, your money will compound a lot faster (and it becomes less important to catch those 100% gains over the long haul).

The other thing about avoiding 50% drops is that a 50% drop or the like engages your limbic system and starts making your brain’s rational decision-making system turn off. You are much more likely to make bad choices when your limbic system is flooding you with adrenaline and cortisol than when you aren’t. I feel fear and greed like everyone else, but I know that both are bad decision-drivers, at least when I’m not actually being chased by a lioness across the savannah.

I hold the Permanent Portfolio (as pseudo-cash) until I have ideas (maybe once I have my charter in several years.) Permanent portfoliio = 25% US Index, 25% Gold, 25% Cash, 25% LT Bonds. I don’t sleep well at night with 100% cash.

Frank, I think you and Bchad should give up discussing asset allocation and portfolio construction, you are effectively speaking different languages.

I’m with Frank though. I hold cash until I get a good idea. Right now I’m on about 40% cash, 60% stocks.

i agree Palantir…aside from client consideration, I think we see Mr. Market different fundamentally…

40% cash man? that’s a lot…i got room for 1 maybe two good ideas this year…still searching…i think not buying some US Banks thus far has been a huge mistake…

.but after having checked up on some recent prices, my biggest is not buying VISA at 65…what turned me off was their balance sheet and negative equity in addition to the price (it was quantitatively expensive, but not qualitatively after having done more thinking)…what a bummer…

MCD is yet another mistake after taking some time to do some analysis…list just goes on and on…

Yeah we are speaking different languages. Ironically, I suspect we would be a good team, though, because of complementary analysis skills (and possibly uncorrelated taste in HCB).

Frank starts with the idea that if your asset selection is good enough, it effectively doesn’t matter how the portfolio is constructed, as long as you have no more than 20% in each asset and some dry powder (maybe 20%). So my guess is that his portfolio construction method is to allocate something like (1-c)/N to each asset, where c is the minimum cash allocation and N is the number of investment ideas. If that (1-c)/N >20%, then allocate 20% of AUM instead.

For high conviction investments, Frank might play with the allocations differently.

It’s a reasonable way to do things if you are very confident in your security selection. It also has the advantage that it is easy, so you don’t waste much time in portfolio construction and can get out there and look for the next underpriced asset.

If you have shorts, however, this method won’t tell you how to size them. You could play with the notional size of the trade if you are shorting, but you’ll definitely need to start rebalancing if any positions change value. Anyway, Frank doesn’t do shorts… he’s in Canada, where it’s too cold for shorts.


My method is more suitable for times where you’re not nearly so confident about your security selection. You think you have an insight and the probabilities are in your favor, but perhaps not by much. This method keeps the consequences of mistakes in check, and means that you don’t always have to be right about the timeframe.

This method will not work badly if your security selection has high confidence too. And this is why I like it. If you have low confidence, it protects you better, but if you have high confidence, it doesn’t penalize you too much. Iff you have some trades/investments that are higher confidence than others, you will want to increase the portfolio exposure to the high confidence positions at the expense of the low confidence ones. But I don’t feel I’m so good at figuring that part out, so I am happy just to do the risk weighting thing.

Incidentally, a fair number of my positions are driven by qualitative insights, not quantitative ones, which is why I often have low confidence investments (I have an idea, but I’m not sure how to measure them, so the error bars are wide). This method allows me to bring some quantitative information into position sizing even if the investment thesis is qualitative in nature.

Not for lack of ideas, just havent gone in depth into many of them , damn CFA guilt, so I’d just rather not buy anything. I really missed out on SAM and ATRI last year. I’d been following those for a while and hestitated to pull the trigger. Maybe over the next few mos I’ll look into General Dynamics more closely. US defense is only going to be cut by 6-7% or so, shouldn’t hurt them too badly.

i agree we would be a good team…its easy to get carried away with one’s own ideas…sometimes errors are not recognized until its too late…

For my own investments, I’ve got my roth IRA split equally between IVV, EFA, and EEM and my 401k invested solely in my firm’s short-term cash account that returns 4% with (as far as I can tell) 0 risk.

I’m becoming more favorable of mean-variance optimization (likely with some sort of Bayesian prior) targeting a constant level of volatility. The level of volatility I would try to target is like the S&P500’s (or a 60/40 stock bond allocation) volatility when the VIX is at more normal levels. When volatility increases, the strategy moves to a more defensive allocation.

Yay, markets are starting to drop. If there’s another 1% decline in the index, getting my elephant gun out.

i am considering BRK…the thing i find so impressive about them actually (aside from buffet) is their Insurance Operations…all the other subs are strong…but if i had to take any of them on their, their insurance holdings is quite amazin…

I’m with jmh… of the portfolio construction methodologies I’ve seen, the Black Litterman model (and variants of it) seem to make the most sense to me. It’s hard to implement though, especially for generating the appropriate inputs to the method. I’ve been searching for a simplified version of it that is heuristically similar, but doesn’t have quite the same data requirements.

You can think of it as a way to blend what you think you know with what the rest of the market thinks it knows. Given that sometimes you know more than the market about something, but more often the market knows more than you, I find it a compelling method.

On another note, have you noticed that people talk about “having a methodology,” when really, what they actually have is just “a method.”

what is the diff between methodology and method?

Method: a way of doing something.

Methodology: the logic or set of knowledge that tells you 1) why the method is appropriate for its purpose, and 2) what the limitations of the method are. You use methodology to determine a method.

I’m not even sure it’s possible to “have a methodology,” at best, you can “have a methodological justification” for your method.

Saying “I have a methodology,” when all you really have is a method, is like saying “I have a biology,” when all you really have is a turnip.

sounds like a bunch of semantics to me…according to one of my fave philosophers Wittgenstein (or however you spell it), if you can’t draw a picture of it, its non sensical…

I spend approximately 0% of my time on portfolio construction. Diversification is lame. I find a good company and buy it. Don’t care how it interacts with my other investments.