Know your Portfolio - Three Simple Charts Can Make a World of Difference

Portfolios change as investments change – make sure it still fits your goals and risk tolerance

A friend of mine used to manage his own investments. He was a good investor and had enough experience to avoid the common mistakes novice investors often make (more on common mistakes). Time progressed and his investments grew nicely.

After a long period of independently managing his portfolio he decided to consult with an investment broker to explore new options and other financial assets. A few moments after the broker reviewed his portfolio my friend was very surprised. He was amazed to find out his once solid portfolio now had over 60% invested in stocks.

Needless to say he learned a very valuable lesson that day. Managing our portfolio requires more than properly understanding risk, selecting the right assets to match our goals and term of investment and avoiding common mistakes. It requires constant and routine review. Even if our portfolio is managed by a trusted investment broker it’s always recommended to review it ourselves.

In order to properly review and monitor our portfolio we require a set of tools which can be easily developed but require some understanding. As always, I recommend consulting with a professional.

The tools, or charts, I will discuss here are all informative tools which enable us, as investors, to get a quick glance at our portfolio and make sure it’s built the way we want it to be. These are very basic and will generate the biggest immediate benefit. In future posts I will discuss more advanced tools, should you find these helpful.

The allocations of your portfolio

Whether we manage our portfolio on our own or simply want to make sure it’s being managed properly we must regularly update and review the allocations of our portfolio. There are three basic and important allocations to monitor and they are: Assets, geographies and currencies.

#1 Asset allocation

Sounds terribly intuitive indeed but when was the last time you reviewed the asset allocation of your IRA, for example?

I can assure you your portfolio today is different from the asset allocation you set out with some time ago. The variation depends greatly on how risky your portfolio was at that time (naturally, since variance is at the basis of the definition of risk). If it’s been a strong bull market the share stocks take up in your portfolio will grow significantly and with it the risk you’re taking.

Assume you’re portfolio was made up of 50% stock and 50% bonds with stocks rising 20% and bonds rising 5%. Your portfolio is now comprised of 54% stock and 46% bonds. The longer the length of time that passed between the initial set up of the portfolio and the review the bigger the difference.

Keeping track of your asset allocation has two main purposes:
1. Making sure you are taking the level of risk that suits you.
2. Making sure you are investing in right financial assets for you.

The asset allocation is best displayed using a pie chart easily constructed with any spreadsheet. I recommend reviewing it monthly as it also helps motivate you towards saving.

The pie chart should be composed of at least the following asset classes, depending on risk:
1. Stocks
2. Bonds
3. Liquidity

More sophisticated assets need to be dealt with differently or divided according to their “ingredients”. Don’t buy what you don’t understand is usually a good advice.

#2 Geography allocation

Another important display of your portfolio is the geographical diversification of your portfolio. The same thing that happens in your asset allocation happens to your geographical diversification. It changes according to market developments.

Assume the share of emerging markets in your portfolio should not pass 10%. Some of these markets have generated returns of over 200% over the last years. Imagine what happened to the share of your portfolio invested in emerging markets, and with it to the level of risk you’re taking.

Building a pie chart to display how you investments are spread over various geographies is easy and should include the main countries in which you are invested.

#3 Currency allocation

Everything I’ve written up to this point applies to currency as well. Invested in USD, Euro, Pounds? Monitor your exposure to foreign or domestic currency carefully. Usually it is smart to diversify investments over currencies as well (notice it is a common and correct practice, in my opinion, to keep the majority of your investments in your domestic currency, if you live in a developed country).

Each Financial asset can have a different parameter for each of these variables. For example we might own a stock of a European company which is priced in Euros. We could also own a bond of a Japanese company priced in Yens.

Each parameter carries with it specific risks and specific exposures. We must be able to control and review these risks and exposures in order to keep our portfolio in shape.