Portfolio Construction

The Australian Stock Exchange provides a podcast for investors. The latest item to show up in the feed (though not listed on the ASX podcast page) is a talk on Portfolio Construction by Dale Gillham, Chief Analyst at Wealth Within.

I listened to the podcast the other day while commuting and found it quite interesting. Mr Gillham makes some good points about diversification, but also seems to confuse some of the basic theory taught in finance courses. The basic Capital Asset Pricing Model (CAPM) assumes that market prices are efficient -- that is, that you can't consistently beat the market by choosing individual securities. If this is true, then your best course of action is to replicate the market portfolio. And the cheapest way for individual investors to replicate the market portfolio is to buy index funds or ETFs.

Any investment strategy designed to beat the market is implicitly assuming that the market is NOT efficient (probably not a bad assumption in smaller markets like Australia's). These strategies will beat the market to the extent that they are able to consistently identify undervalued investments. Such a strategy requires assuming a reasonable amount of company-specific risk -- the more you diversify, the closer your portfolio is to the overall market and the closer your return is to the market return.

So, when constructing your portfolio you need to be clear about your assumptions. Do you believe the market is efficient? Then go with index funds. Do you believe the market is inefficient? Then you need to decide whether you can consistently select undervalued companies. If you can't (or if you don't have the time), then index funds are still your best bet.