Investing is the buying, holding, and selling of financial assets over a period of time. The purpose of this activity is to forego consumption today so that you can enhance your future consumption activities through increased wealth that is gained via investing in financial assets.
Assets produce this greater wealth through returns, and those returns contribute to end-of-period wealth, which is supposed to be greater than beginning-of-period wealth. That period is variable and different assumptions and models can be used for different time periods.
Returns in financial markets are uncertain, which is why diversification is a key to increasing return potential while diminishing decreasing return potential. This the key fundamental concept behind portfolio theory.
Portfolios are collections of assets put together with an overarching theme or mandate—that can be as simple as it is the portfolio the client wants to as complex as being a multi-faceted smart beta fund with active management driven by stress-testing risk management.
Whatever the portfolio and how it is made, all portfolios can be considered themselves assets. While portfolios are collections of assets, once combined that portfolio can itself be an asset that, theoretically, can be bundled and sold to others. This is the basic theory behind ETFs, CLOs, and many other securitized products.
Portfolio construction at the professional level is designed to optimize the quality of the portfolio as an asset, which can be done through a variety of conceptual prisms. The initial portfolio theory of Harry Markowitz is 70 years old but still is the basic principle of modern portfolio theory.
Markowitz’s theories are typically employed at the level of asset allocation; portfolio managers will use MPT to construct the best mix of assets to have, theoretically, the ideal future return.
This is separate from security selection within portfolios. In other words, the decision to buy Stock A over Stock B relies on a different kind of analysis and skill set as the decision of how much of Stock A to include within the portfolio.
How to produce the optimal portfolio relies on a lot of math, but the math ultimately depends on some basic questions that have nothing to do with math. They really have to do with feelings. The owner of the portfolio’s character is a factor. Does the portfolio owner want more risk or less risk? Why? What is their time horizon, their end goal, and their cash flow needs?
This is why funds cannot be compared to one another without understanding their mandates, their goals, and their target investor audience. No two investors are the same and no two portfolios are truly comparable.
Once one understands this, one can begin to dig into whether a portfolio has been made intelligently and with care. By using ideas such as the efficient frontier, one can easily back test funds to see how their portfolio creation and risk management works. Taken to its extreme, one can learn a lot not just about how that fund works but how fund investing works by such an analysis.
That’s not too surprising; risk management, diversification, and optimizing positions for maximum returns are the core of what finance is all about.