Part 1: Objectives and Risk Profiles

Portfolio construction is the term for designing and implementing a portfolio to meet a client's goals. Whilst every client is different, there is one common goal, namely growing portfolios as safely as possible.

Redefining Risk: Beyond the Textbook

Building investment portfolios is about getting the best mix of risk and return. Unfortunately, it is very hard to quantify risk so we generally use volatility because it is easy to measure. Volatility is not the perfect way to measure the risk that a portfolio will not meet its objectives (the most important risk), but it does provide a really good indication as to how much a portfolio might lose in any time period.

This is very important because at Bellmont we try to match a client's portfolio with the client's willingness to suffer ups and downs in performance along the way.

At Bellmont, we distinguish between perceived willingness and true capacity to take risks. We distinguish between stated and revealed preferences.

  • Stated Preferences: How we think we will act when portfolios fall.
  • Revealed Preferences: How we really act when real dollars are at stake.

We aim to bridge this gap so our clients are better prepared for what might happen.

Whilst we accept volatility is one measure of risk, it is also the source of opportunities and not necessarily something to fear. For example, if a high-quality asset drops 50% in price, a "textbook" measure of risk rises, but investing in that asset is actually safer because it is now significantly cheaper.

In everyday life, we make risk assessments more intuitively. For example, we know that in any given year, the weather can range from scorching sun to torrential rain. However, knowing a range of outcomes doesn't tell you whether to carry an umbrella today. To make that decision, you might look at the sky. If you see dark clouds and feel rising humidity, you recognise that the probability of rain has increased, regardless of range of possible outcomes.

In finance, volatility tells us about the range of possible outcomes by referencing history. Unfortunately, volatility is not very useful in predicting the future.

At Bellmont, we don’t just look at the historical averages. We look at the ‘financial sky’, valuations, economic fundamentals, market sentiment and many other metrics to assess the likelihood of a storm. We believe it is far better to carry an "umbrella" (protective positioning) when the clouds are gathering than to simply rely on the fact that it didn’t rain this time last year.

Integrity in Benchmarking

Once we have an agreed understanding of how much risk you can bear, we align your objectives to an appropriate benchmark and we calibrate your risk tolerance around how far you are willing to deviate from that benchmark.

Some benchmarks refer to the average of other managers, a practice that has its uses, but also its limitations. Because it is not possible to invest in an average manager in advance, peer analysis is very limited and makes ‘apples-to-apples’ comparisons nearly impossible.

We believe the most honest measure of success is the opportunity cost: the low-cost, transparent alternative you could have chosen instead, which is usually an index less the cost of accessing that index.

We are Mindful of Risk Creep and are always 'True to Label'

We keep a watchful eye on how an investment is described to ensure that what is ‘in the box’ matches the label on the tin.

For example, two portfolios might both be labelled 80/20 (80% Growth, 20% Defensive). However:

  • Manager A might use leverage or high-beta stocks to manufacture ‘outperformance’ during a bull market, in other words, stocks that rise more than the market in an upswing, and fall more than the market in a downswing.
  • Manager B might use value equities and infrastructure allocations which can provide a ‘less than market exposure’ in an upswing, and equivalently less of a drawdown when markets fall.

In a rising market, Manager A looks like a genius. In a crash, their skill is revealed to be nothing more than hidden risk. We believe that if you are going to take on extra risk, it should be deliberate. Extra return should come with any additional risk and it should be a choice made when assets are cheap, not a permanent, disguised feature of your portfolio used to inflate performance numbers.

This post is part one of a three-part series on portfolio construction. Parts two and three will be released next week and the following week .