The portfolio approach to taming emotions

For many, investing is not always a rational decision - it's an emotional one. That's true even for professional traders at banks and brokerages, says Andrew Lo, a finance professor at the Massachusetts Institute of Technology in Cambridge Massachussets, whose research focuses on why rational investors often make irrational decisions. For traders, it takes discipline to combat emotion.

Discipline comes through a written investment policy statement (IPS). That's how pension funds set out return expectations and establish acceptable degrees of risk. Most Canadians don't have an investment policy statement, says Tracy Chenier, Talvest's vice-president of product development and management in Montréal. As a result, they don't know whether to pull out or buy when the market dips. A well-planned portfolio, however, tolerates risk a lot better. We suggest a 5-step approach to building an optimal investment portfolio, starting with a written investment policy statement such as our BLUEPRINT approach.

Defining an investment policy is an opportunity for investment advisors. "What advisors can do is really shape the context that the investor finds himself in, not the one he thinks he's in," Chenier says. Many investors may not quite realize what their investment horizon really is. They need to understand that the longer the horizon, the greater the room for risk. In turn, the greater the tolerance for risk, the more investments are available for an optimal portfolio.

Once the investment policy is written up, we find themselves analyzing current client portfolios which may well be haphazard fund groupings with little diversification, whether across asset classes, countries or investment styles. That's step two: identifying what's in the portfolio and what should be in the portfolio to ensure proper diversification across asset class, investment style and geographical region.

Step 3 is to take that portfolio and rebuild it, with the tools provided by modern portfolio theory. Modern portfolio theory looks at how much a given investment will return, how returns will vary year by year and how they correlate with each other. That leads to the concept of optimization: choosing a basket of investments that will yield the highest returns for a given risk profile over a specific horizon. This is how our BLUEPRINT approach works.

Then it's a matter of optimizing a portfolio for the appropriate horizon. That's step 4. An investor who expects to draw down assets in less than five years will probably need a higher allocation to fixed income. With a long investment horizon, investors can hold assets that have higher risk, but better long-term performance.

Maintaining a disciplined portfolio approach doesn't end there, however. Step 5 is to maintain, monitor and rebalance a portfolio as needs or risk tolerances change. "You don't rewrite that investment policy every year. In the course of our lives, we go through different changes: we have children, we change jobs, we retire; that prompts us to revisit our plan," says Chenier.

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