Under the efficient market hypothesis (EMH), asset prices reflect all available information
The theory behind the intuition is familiar – stock prices adjust quickly to new information, which makes their past performance irrelevant and their anticipated future returns decisive
Implications are irrefutable
- Single stock selections as attempts to second-guess the market by hoping to 'front-run' information make no sense - the market price cannot be ‘beaten’
- Asset diversification as buffer against market randomness is fool-proof (like ‘not putting all one’s eggs in the same basket’)
However, it remains a challenge to monitor information, a continuous stream coming in broad strokes and in fine details
At stock level, information will always be hard to process and to rank – how to be sure what matters a lot and what would have little impact on individual share prices ?
Sectors and industries might act as essential filters, bringing a sense of order to a jumble of data
Starting out with multiple strands of information, industrial trends will focus on what is significant overall, bridging the vast mass of information selectively to give shape and meaning
Pininvest structures information in distinct themes, highlighting industries or entire sectors, as building blocks of portfolio diversification
Pondering information is not a wild-goose chase
The hard thing about investing decisions of individual stocks is the evaluation of contextual information
Intuitively, investors project their own anticipation of a bright future on stock selections
They assume, somewhat optimistically, that their opinion, supported by whatever information they gleaned in public sources, will run ahead of the market
And indeed, intuition will have its day, sometimes spectacularly so… and Tesla
But then, there is risk
Committing cash to an investment portfolio is linked to an element of risk
Risk needs to be properly understood – measured and reasonably contained – putting investments decisions in a different league from gambling and casino bets
If choices are to be made with confidence, even if intuition is to be accounted for as a valued component of investment decisions, palatable investment goals must be laid out
Spelling out investment goals
These goals are more straightforward and easier to spell out by stepping away from day trading
Looking beyond the day or the month, portfolio construction is a two-step process, laying the groundwork of diversification first and filtering asset choices selectively next
Diversification is based on specific asset categories, on sectors and on industries
Diversification – in a rarely achieved ideal world – combines weakly correlated asset categories, where poor performance of some is rebalanced by outperformance of other assets in the selection
Even though this hope may go unfulfilled, portfolio diversification undisputedly mitigates the investor’s exposure to risk
Portfolio risk is always lower than the sum of individual asset risks
Because purposeful risk mitigation is a fact, not a hope or a promise, thought given to diversification always comes first in portfolio management
Building great portfolios
The reputation of some of the greatest investors is buttressed by diversification, even if public attention will focus on individual company choices
This matters because diversification guarantees the balance between performance and risk exposure with which the investor is comfortable
Even though diversification comes in many guises, the combination of sectors or industries, equities, bonds, commodities and other classes, is always the foundational component of the investor’s insights
This ‘secret sauce’ is grounded in the relentless search of information from primary sources, not necessarily related directly to finance but mirroring broad trends in the global world
It comes as no surprise that great investors are great readers
With clarity about favored asset categories, and their respective weightings, Pininvest themes - such as Trends - are the building blocks of the portfolio framework
Asset selections will gain in clarity by comparing company performance with its direct competition in themes defined by the same (or closely related) underlying industries
As will be discussed in a follow-up note, Pininvest analytics, asset fundamentals and ratios, provide guidance in filtering asset performance and volatility drivers
The choice of companies and funds will determine the final outcome, but nothing matters more to performance and risk exposure than the selection of categories, sectors or industries, to characterize the portfolio