Don't fall into the trap of ad-hoc portfolios.

IN the course of our work, we are often mandated to review and restructure investment portfolios that clients have acquired elsewhere. Unfortunately, many of these portfolios arrive at our restructuring table bereft of clear strategic principles.

Think global: one should seek the best investment possibilities no matter where they are.

Diversification is often ad-hoc. Many are under the misimpression that because they have bought a variety of instruments, they are diversified. Very often, if there is a diversification theme, it is built around fund launch 'promotions' or 'hot' IPOs. Many also have the impression that the more complicated and 'sophisticated' the product, the better off they are - the seduction of being labelled sophisticated.

Heavenly simplicity

We believe in keeping the investment process simple because investing is, in principle, simple.

Virtually, all investment products are combinations of a few key building blocks: equity, fixed income, cash, options, and precious metals. One of the most important equations for assessing the value of any investment, for example, is that for the sum of discounted cash flows, whereby V=fair value of security, Ct=cash flow, k=required rate of return; and the other is Black-Scholes options pricing. The compactness of the equation satisfies the 15-cm rule. My professor used to joke that equations longer than 15cm are untrustworthy because heaven is unlikely to be a sweatshop.

Hellish details

The rest are essentially equations which facilitate the processing of input data for the above two key equations or are inputs themselves. Herein is the devil. The problem has always been the interpretation of incoming economic data eg GDP, inflation, interest rates, productivity, unemployment, currency exchange rates, return on capital, etc. These are data which often affect asset markets anomalously or non-linearly eg very low inflation exposes companies and economies to deflation, yet excessive inflation is also bad as it distorts pricing and productivity signals for the economy.

Clouding the non-linear effects of economic data is the noise from misperceptions - here are some key ones:

Valuation relativity: Bottom-up stock pickers often maintain that every security has an absolute intrinsic or true value, no matter the economic environment.

Looking at any multi-year securities chart this is not apparent - either intrinsic value is very transient or appears to be constantly changing. We believe that there is no such thing as an absolute 'intrinsic' value. We believe that all fair values are relative.

Indeed, this is implied from the equation for assessing the sum of discounted cash flows. The required rate of return, k, is the sum of two interest rate components: the long-term government bond yield and the risk premium of the security. Even if the cash flows from the security are absolutely certain, k is highly variable as both the long-term government bond yield and the risk premium of the security varies considerably over business cycles. This is why a market trading at 10 times price earnings ratio may be expensive while one that trades at 20 times may be cheap.

Wide Moats: We often hear that 'such-and-such a market has lower valuations because it trades at a lower price-to-earnings or price-to-book ratio'. This is misleading as it assumes that valuation is purely a function of financial ratios.

We believe that the competitive advantage of a company or an economy is the most important factor in valuations. Quantitatively, it is the estimate of how many years a business or an economy can maintain higher than normal returns. Qualitatively, it is that potent cocktail of management strategy, execution, proprietary processes, patents, and brands.

Competitive advantage is the reason why two financially identical companies could differ considerably in stock market valuations. It is what Warren Buffett calls the 'wide moat'.

Contract manufacturing, an industry which arose because of companies focussing on their key competitive advantages, is an interesting business but it eventually confronts the wide moat or glass ceiling created by someone else's brands and patents.

Investment patriotism: I was recently asked at a seminar whether we should invest more in our own country.  Should Asians invest only in Asia or Europeans only invest in Europe.

We believe clients should separate patriotism from their investment needs. Clients should seek the best investment possibilities no matter where they are.

One major problem with just investing in Asia is that although Asia is very plugged into the global economy, its stock markets aren't. This is because a significant portion of profits made because of Asia are not manifested in Asian but in G-3 stock markets. Moreover, if one's job is dependent on the economic health of Asia, it pays to diversify investment assets into other markets.

Principle-centred: How do we make sense of a clearly non-linear, noisy investment world? The overwhelming evidence is that asset allocation is the most crucial factor in making your investments work for you. For example, the best global technology fund would have grossly underperformed the average government bond fund in 2000, 2001 and 2002. We believe that clients should establish the principles of their asset allocation strategy before they invest in anything. An asset allocation strategy is the starting point of the diversification process, and not vice-versa.

One such possible principle-based approach is to establish answers to the following questions:

What is the purpose of the portfolio?
The answer to this simple question is crucial as it compels one to ascertain one's need(s). For almost everyone, retirement is a non-negotiable goal and this need has to be met, at the very least.

What is one's investment risk tolerance?
One's risk tolerance will guide one's strategic asset allocation - this is the mix of equities, fixed income, cash, etc one ought to have over the business cycle. A moderate-risk investor would generally have about 55 per cent in equities over the business cycle. As advisers, we help our clients to vary this over the investment cycle through tactical asset allocation which is driven by the relative attractiveness of different asset classes over the business cycle. For example, our moderate-risk portfolios have had more than 55 per cent in equities since April this year in anticipation of a liquidity-driven rally which has occurred.

How should one diversify?
By industry sectors or geographical regions or a combination of all? With a small portfolio, one may not be able to mix diversification strategies. However, larger portfolios could adopt a mix of diversification strategies - diversifying diversification strategies. Using unit trusts, the individual today could essentially mimic the approach of large pension funds. Generally, it may not be feasible to create a sufficiently diversified portfolio using individual securities if the portfolio is less than $3 million in size.

What criteria should one use to select investment instruments?
Do not chase short-term (less than one year) performance. One is probably better off with an investment instrument which has never topped the rankings but has shown consistent above-average performance over various time-horizons as far back as possible. This is far more difficult to achieve as this is reflective of successful processes and culture - which takes a long time to develop. Moreover, consistent performance is important as consistency reduces the likelihood of one's asset allocation call being messed up.

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