How to Combine Asset and Industry Classes into a Portfolio to Minimizes Risk

personal financeHaving dug into the basics of how it is that we can make sure that we diversifying our investment base throughout a given industry sector to minimize our exposure to unsystemic risks, we can now start combining our positions in these sectors to come up with a full investment portfolio that mitigates out as much risk exposure as possible.

To create our overall portfolio, we are going to follow a very similar series of steps to the ones we used to select companies within the industries themselves. We’ll start by looking at what kinds of risk exposures these industries all have, and making sure that we distribute these risks evenly, so as to not over-expose ourselves. For example, information technology and energy securities are both industries that are heavily tied to the business cycle, and both will produce the majority of their returns through capital gains. These positions should be offset by a more stable industry such as the consumer staples and financials portfolios, which we will have very likely built up to be the more stable portions of our portfolios that are meant to provide a strong fixed income return.

By offsetting various industries against each other equally, in terms of unsystemic risk exposure, we are putting ourselves in a position that ensures that our portfolio will have exposure to as many opportunities as possibly within the overall economy itself, while spreading out our risks as much as possible to prevent losses. This means that our portfolio will ideally perform well both in up and down markets, because of the way in which different industries will create different levels of returns throughout different periods of the business cycle. Combined with the weightings of capital gains and fixed income returns, we will be able to depend on a portion of the portfolio for regular installment payments, while still maintaining exposure to the larger potential upside that is associated with jumps in stock prices for those companies that outperform.

Looking at what kind of a result we have so far in the hypothetical portfolio that we have built, we are currently looking at a risk-weighted index of the entire market. By taking on what is known as the ‘market portfolio’, we have placed ourselves in an extremely efficient investment position. However, because of the way in which market volatility will continue to change the weightings of our portfolio because of different levels of returns, we now need to come up with a strategy for keeping the portfolio in check as it operates, so that we do not become over-exposed to positions that have recently over-performed, and lost exposure to positions that have recently under-performed.