To build the perfect portfolio, answer these 4 questions by Richard Waddington, 5th March 2015

It’s fair to say that good Portfolio Managers earn their keep. Building an investment portfolio is a rigorous process that involves research, knowledge and diligence, as well as good instincts and strong self-discipline.

To do this well, I think that you need to answer four simple questions.

Here they are.

1. What am I trying to achieve?

The first question you should always ask is: “What am I trying to achieve?. This goes for whether you are making the investment decisions yourself or you’re giving your money to a third party Fund Manager. If you are the Fund Manager you'll need to ask "What is my investor trying to achieve?".

It might sound obvious, but you would be surprised how often the answer to this question is taken for granted or even overlooked altogether.

You should always ask this question without giving any consideration as to how you are going to do it. Otherwise you're likely to get bogged down in the detail of your investment choices, and this will alter your thinking about what you are trying to achieve.

Always remember to be realistic. Don’t come up with fanciful or unachievable goals that are going to cloud your judgement when it comes time to trade. Be clear and certain about what you are trying to achieve.

2. What's my Edge?

Once you’ve worked out what you want to achieve, ask yourself what’s your ‘Edge’ for achieving it. In other words, what is it that separates you from any other investor or portfolio manager?

Here’s a tip for answering this question. There’s no such thing as a free Edge.

Your Edge comes directly from your work. It may take the form of more detailed analysis, better models, better data or anything else that you do particularly well. But it always has to have a grounding in something you do better or know better than anyone else.

If it’s freely available, it’s simply not your Edge.

It's this Edge that will drive your asset decisions and lead you to make a call on which assets to own or ‘go short’: which assets you want in your portfolio.

But you're not finished yet. The assets you have just selected need to be put together in a way that gives you the best chance of achieving your goals (the answer to Q.1) and that still involves answering questions 3 and 4.

3. What does the rest of my world look like?

The third question to ask is what the rest of your world looks like. What other assets do you own? What other risks are you exposed to?

The answer to this question has a big impact on your perfect portfolio. Answering it well means that two people with the same goals, the same edge, and the same asset decisions may end up with two very different looking portfolios.

4. How do I bring all this together?

You now have your answers to these 3 questions:

So how do you use this information to build your portfolio?

This is by far and away the most difficult question to answer. That’s because you must use all the information you gathered in answering Q's 1-3, and do it consistently.

It is very common to let human qualities like emotion or distraction get in the way at this stage, and when that happens, your carefully prepared responses to Q's 1-3 go out of the window.

If you want to be successful then you must perform this task: combining the three answers consistently every time.

And that is why we at Sherpa Funds Technology developed SherpaORS, a tool specifically designed to answer Q4 and produce an optimum risk size for every single trade.


Why Size Matters by Richard Waddington, 25 February 2015

In my 20 years trading in financial markets I watched my fellow traders both make and lose a lot of money on behalf of their clients. Often the same traders who would pull off a series of wins would be the same ones who soon afterwards suffered a massive loss.

In fact, of the 1,000 or so people I worked or dealt with over the years, I could probably count on one hand the number who had consistent returns.

And I wasn’t one of them.

Maths in Asset Management: Man and Machine

Several difficult conversations with clients made me think about the role that maths could play in aiding consistency and improving the relationship between asset managers and their Investors. So in 2011, I took a two year sabbatical to research this question.

One conclusion I ended up with came as a big surprise to me...

When it comes to asset selection, the human skills of a portfolio manager are very valuable.

My research showed that analysing which assets to invest in was rarely a pure mathematical exercise. Instead it involved characteristics only humans possess - skills such as intuition, relationship building and the sort of complex and un-definable pattern recognition that our brains are very good at.

But there is a caveat.

Trading: the Tale of Two Decisions

The second issue my research revealed is that selecting which stocks (or FX, Rates or Bonds! will go up or down is simply the first part of the money making equation. Just as important is the percentage of a portfolio you allocate to that decision.

In other words, the size of the trade matters way more than many traders and managers give it credit for.

Too Big or Too Small?

If the trade is too small you won’t get rewarded for your skill and insight. But if it’s too large, and you are wrong (there are always times when you will be wrong), you will lose too much. When this happens investors are likely to take away your mandate altogether.

When I witnessed a big loss it was usually because traders got the decision about the size of the trade wrong - not the decision about which asset to select.

That’s because those same human emotions that make us great at asset selection, can hold us back when it comes to knowing how much to allocate. Emotion and the act of buying or selling simply don’t mix.

And where human skills can help in asset selection, human emotion interferes in the sizing decision.

So what is the Optimal Size?

The final - and most important insight - my research showed was that there is always an optimal size for any investment. This can be worked out by properly understanding an investor’s risk profile and then applying advanced maths.

When you get this right, you don't just get more consistent returns. Conversations between fund manager and investor become much easier: there are no surprises. Instead there is a direct link between the risk tolerance of the investor and the portfolio that the Asset Manager constructs on his/her behalf.

And that’s exactly what our product, Optimal Risk Sizing, can do.