The Final Step: Portfolio Construction

Portfolio construction is the final component of a well-designed asset allocation approach. The first step in this process is to set the mix of stocks and bonds in the portfolio based on the investor’s goals and risk tolerance.

Investors and advisors often underestimate the importance of the stock/bond decision, which, more than any other, will tend to drive the level of risk in a multi-asset portfolio.

The Role of Risk Factors
Next, investors should consider populating the equity and fixed income “buckets” in their portfolios with multiple asset classes and strategies. One question is whether these allocations should be based on asset classes (such as large-cap and small-cap stocks or investment-grade and high yield bonds) or on risk factors.

Academic research has uncovered a number of risk characteristics that appear to explain security performance. For equities, these risk factors may include market beta, size, value, momentum, and quality. For bonds, risk factors include duration (interest rate risk), spread, and currency factors.

Some analysts believe that allocating to these factors instead of to traditional asset classes can improve diversification. My own view is that both approaches—asset classes and risk factors—are helpful if used in the right context.

Also, investors must decide whether to employ actively managed or passively indexed strategies in their portfolios. I believe that skilled active managers with a disciplined process and reasonable fees have the potential to contribute to better investment outcomes.

A Comprehensive Approach
Target date glide paths can provide a useful guide to adjust the stock/bond mix based on when an investor is expected to retire. This eliminates the need for investors to adjust their portfolios periodically to reflect their changing risk tolerances.

In my view, effective glide paths should seek to integrate capital market assumptions, promote appropriate diversification, and incorporate behavioral preferences. The resulting portfolios should reflect investors’ risk tolerance as well as their investment time horizons.

A key element of T. Rowe Price’s target date investment process is that it combines quantitative analysis with independent judgment and experience. We also seek to add value via active security selection and an active TAA process.

T. Rowe Price’s Asset Allocation Committee guides the decisions incorporated in our glide path design methodology and our TAA process. The committee seeks to combine fundamental and quantitative techniques in a “best of both worlds” way.