Investing is a lot like cooking. It’s not only a matter of having the right ingredients – but you have to also carefully measure each ingredient at the right time in order to be successful.
So, how does portfolio optimization work? How do you build an optimal portfolio? It’s not enough to simply ensure the quality and value of your securities. You must also pay careful attention to how your portfolio is built.
Luckily, there are certain portfolio construction techniques you can apply to achieve an optimized portfolio. In this article, I propose a portfolio construction technique that has been proven to be successful in outperforming benchmarks over the long term.
Before I explain how to build the optimal portfolio, let’s discuss how the vast majority of investment products are constructed.
Understanding Benchmark Indexes
Most investment portfolios, such as mutual funds, exchange-traded funds and custom portfolios, are built to closely replicate their benchmark.
For example, a stock benchmark index is simply a basket of securities that represent the composition of a stock market. It is made up of the major stocks of its market, and each stock is weighted by the ratio of its market capitalization in relation to the total market capitalization of the market.
The market capitalization represents the total value of a security or an index’s underlying securities. In the case of a company, it is the number of shares issued by the company multiplied by their price. In the case of a country or a regional stock exchange or index, it is the sum of the market capitalizations of all the securities that make up the market.
The best-known indices are the S&P 500, the S&P/TSX Composite and the NASDAQ Composite. The S&P 500 is the benchmark index in the United States and represents the 500 largest public companies in the United States. The S&P/TSX Composite is a Canadian index and represents the 300 largest public companies in Canada. The NASDAQ Composite is a U.S. index composed mainly of high-tech stocks and the DJIA represents 30 U.S. blue chips (i.e., very large companies that have proven to be trustworthy over long periods of time). There are also indices for all stock exchanges around the world and for almost all investment categories.
Most indices are constructed based on a selection of a country’s largest public companies that are assigned a proportion that represents their weight in terms of market capitalization in that basket of stocks. In other words, the proportion of a stock in the index is calculated by dividing the market value of the company by the combined market value of all the companies in the index. Therefore, the larger the market capitalization of a stock, the greater its weight in the benchmark.
This is how the most commonly used financial benchmarks are constructed.
The Market-Weighted Portfolio: Flaws and Drawbacks
Most indices are used as a building block in setting up an investment strategy. In fact, many portfolios are simply an identical copy of their benchmark. The portfolio construction structure that is based on its benchmark is called market weighting.
Although it is the most frequently used method in structuring a portfolio in the financial industry, several studies have shown that it is not the most efficient and that it is possible to better structure portfolios to obtain higher returns. In fact, the biggest flaw of market weighting is to overinvest in companies that are too expensive and underinvest in companies that are cheap.
For example, the S&P/TSX 60 is the stock market index that includes the 60 largest companies in Canada. At the peak of the tech bubble, Nortel was by far the highest-valued company on the market. Its stock represented 40% of the Canadian index. In other words, index investors had 40% of their money invested in Nortel, a single stock, compared to 60% of their money spread over the other 59 stocks put together (on average about 1% in each stock). This is a drastic example of an index strategy that encourages overinvestment in companies that are overvalued.
The Equal-Weighted Portfolio: Implementation and Benefits
Of course, maximizing returns and optimizing portfolios are well-studied areas in finance, and countless studies have been done on this subject. Unfortunately, the theoretical results seem very difficult to recreate in practice. Researchers have therefore tried to soften certain hypotheses to be able to reproduce an optimal portfolio in practice. The result is quite simple but very functional. It’s called the equal-weighted portfolio.
The equal-weighted portfolio, which consists of investing an equal amount in each stock, seems far too simplistic to be effective. However, it has been the subject of numerous studies and the results are very conclusive:
First, the main flaw of the market-weighted portfolio is corrected: the equally weighted portfolio is not over-invested in expensive securities.
Second, the equal-weighted portfolio is better diversified than the market-weighted index portfolio.
And third, it allows you to sell securities that have risen in value and buy back those that have fallen – automatically, without managerial error.
Finally, when we evaluate the performance of the equal-weighted portfolio across different periods and markets, we almost always have significantly better performance. At Claret, we have accurate market data and state-of-the-art IT tools that allow us to successfully develop this strategy for your portfolios.
In conclusion, the equal-weighted portfolio seems simple at first glance, but rebalancing, or putting the right weight back into each stock, adds some difficulty. This strategy can be combined with stock selection techniques to generate an even better-than-expected return.