Building the portfolio

​After having written about FOMO and the importance of an entry/exit strategy, it is now time to talk about how to build a portfolio.

We all know that our portfolio should be diversified, but why? 
Fundamentally all of us are looking after maximizing the earnings while minimizing the risks. This can be effectively done by holding stocks, commodities and bonds. Easy, right? Yes, not a braniac. The question then become how much to allocate to each of the asset or strategy. We are now entering a trickier territory in which as investors we have to face the trade-off between risk and reward. We all want the strategy that in the long run gives the highest return (even knowing a priory the risk involved) but then in real life when we experience too much drawdown or a bad year we might rush into bad decisions such as revising our approach and thus ineffectively try to chase the tail.

When it comes to portfolio optimization, I personally use two approaches: risk parity and the Markowitz approach. I ll spare the post from the mathematical details, if you want to know more either ask or Wikipedia has good enough info. I find the approaches complementary mostly because the risk parity might not always give the risk-reward profile we are after (despite being very easy to compute, not quite the same for the Markowitz).

In the table below you can see how these two models are applied to a portfolio consisting of stocks (S&P500), gold and bonds (US medium term). The risk parity approach gives returns in between holding solely bonds or equities/gold while having low drawdown, higher Sharpe ratio and low correlation with the market. Using the Markowitz approach, while maximizing the Sharpe, the returns are as equities/gold while the maximum drawdown roughly half of what it is experienced in the last 15 years with these two assets. If on the other hand the drawdown is minimized then the results are very similar to the risk parity theory. 

Two approaches and three different answers: up to our risk appetite to decide what to follow.