How to build a portfolio - BRD - Groupe Société Générale

We remind you once again, investments on the capital market are risky. A well-known risk-mitigation method is to avoid keeping all our eggs in one basket. In the portfolio theory, this strategy is called diversification. Before proceeding with the portfolio structure, the investor must keep a reserve for his current needs and for unpredicted emergencies. The next step consists in determining the investor's propensity to take risk. Risk tolerance means the investor's capacity of accepting the risk and depends on the investor's willingness and ability to undertake such a risk. There is often a conflict between the willingness to expose oneself to risk and the ability to do so. Each individual enters the investment equation with a unique set of financial circumstances, targets and limits which will clearly influence his choices. Nevertheless, there are a few "models" that play an important role in setting the risk tolerance and the investing objectives.

Financial and economic theory was built on the assumptions that investors are rational, they act based on the available information and they wish to maximize their fortune. Lately it has been apparently acknowledged that, especially under stress, psychological considerations play an important part in the decisions made by investors.

According to the classical theory, the rational investor represents:

Risk adversity (preference for the asset with the lowest volatility);
Rational expectations (coherence, accuracy and lack of preconceptions);
View of the portfolio as a whole (evaluation of the assets in terms of their contribution to the portfolio and not as isolated entities);

According to behavioural theories, the typical investor:

Manifests aversion towards loss
Has preconceptions
Separates the assets when he evaluates them.

Based on these hypotheses, four psychological types of investor have been defined:

The prudent investor: needs financial security, looks for low volatility products, dislikes making decisions, but is rarely influenced by the others - hardly listens to professionals' advice, misses opportunities because of his hesitations, makes a small number of transactions, reduced volatility.
The methodical investor: relies on facts, uses trading analyses and strategies. Even when his work is rewarded, he keeps looking for information. He is not nervous, does not get attached to the assets. He is relatively prudent.
The spontaneous investor: permanently adjusts his portfolio following his impulses and the evolution of the market. He does not see himself as an expert, but does not trust advice.
Among the spontaneous investors there are some winners, but most of them do not reach the average profitability level (lot of fees to pay). They are more afraid of missing their chance than of enhancing the risk level of their portfolio.
The individualist investor: gathers information, judges, is not afraid of action. He is very confident in his own judgement and work, and in the fact that he will meet his long-term objectives.

Apart from the psychological profile, a series of other factors also influence the risk tolerance of each investor. The following need to be considered:

Source of fortune. There are investor classification schemes based on the fact that the manner in which the investors acquired their money is relevant for how they perceive risk. Successful entrepreneurs are aware of the consequences of their decisions and ready to take things in their hands, and they understand better how economy works. One who received an inheritance and knows he's run out of old rich relatives should be more careful with one's money. He knows fewer things of the market and is less willing to take chances.

Measure of fortune. Given the subjectivity of evaluation, it is difficult to categorize the investors by the size of their fortune. Nevertheless, an investor who considers that he has a small fortune proves low tolerance to the volatility of his portfolio. A portfolio that is not able to support the investor's life style should be considered small.

Life stage. Risk tolerance decreases constantly along investor's life. Young persons have a longer time horizon. Anyway, investors rarely fall in one single category and the relationships established among all the matters previously discussed should be considered carefully. To become aware of their risk tolerance, investors must ask themselves:

In terms of portfolio volatility: how much can the portfolio value vary without affecting the investor? Naturally, the bigger the investors' fortune, the larger their risk ability.
In terms of obligations: how big is their fortune as compared to their obligations (children support costs, the need to acquire a new car, etc.)? The smaller the obligations and the larger the fortune, the bigger the risk, naturally.
In terms of their financial solidity: what are their possibilities to cover from other sources the potential failures of their portfolio to contribute to their flow of expenses?

The investor's risk tolerance results from the combined answers to questions 2 and 3. Depending on his risk tolerance, the investor will establish his target yield. It is obvious that a low risk portfolio cannot provide high a yield. Naturally, a high risk does not guarantee a big return, it merely makes it possible. The investor's objective of obtaining yields as high as possible according to his risk tolerance is established within the context of important limitations, which are: the investor's cash requirements, the investment's time span, limits set by the tax system, legal limitations and special circumstances.

All the stages above will help the investor determine what portion of the invested amount to allocate to shares and what portion to fixed income instruments. This stage is called strategic allocation and it needs one further component to be complete: an overview on the macroeconomic conditions, the trends of evolution of the exchange rates, of inflation rate, of the shares prices, etc. If the analysts expectations and of the business community hopes (usually largely described in the press) are optimist, this allocation will favour shares; in the case where, under the same circumstances, their expectations would be more reserved or rather bleak fixed income instruments will dominate the portfolio. This is a continuous stage. At any time, there may occur events likely to change the perspectives of economic environment's evolution, therefore the investor should permanently monitor the actual situation so as to change in time his portfolio's allocation by groups of assets.

The next step is the tactical allocation. For each group of securities (equities, corporate bonds, municipal bonds, government bonds, etc), the investor must select the actual assets, the shares of which company to buy, for what price and at what time. The same for the other groups, as well. Investing in more companies' securities eliminates the so-called unsystemic risk. The investor will not lose the entire fortune if one of the companies in his portfolio encounters difficulties (looses important clients or big contracts, must pay damages to a client or goes bankrupt), as it would happen if he chose to put all his money into a single share. But making an optimal portfolio does not consist in merely gathering together assets that individually have the optimal risk/return features for the investor. What the investor should do is look for shares that, in correlation with the other holdings in the portfolio, would increase its return and maintain (if not even decrease) its risk. For example, when a portfolio includes shares of an aluminium manufacturing company (large energy consumer, the profit of which falls with the increase of the electricity price), it is best to include in that portfolio shares of an electricity production company. Or the shares of the car manufacturers (whose sales decrease with the rise in the oil price) may be balanced by the presence in the portfolio of shares of companies in the oil sector.