For long term portfolio's (10 years+) I take a top down approach to security selection. Multi-factor modeling when valuing securities. Once the portfolio is optimised according to appropriate risk/return objectives I use Technical analysis for short-term market timing to enhance risk adjusted returns.
Current long term portfolio includes Emerging market equities (heavy weighting towards India), Crude Oil, Heating Oil, Nat Gas, Gold, Silver and BBB rated Bonds or above (Norway, Canda, U.S, Hong Kong, Singapore, Australia, Sweden, Denmark, UK, Germany and Mexico).
The first question for constructing portfolio starts with the specific risk/return profile over a specific time horizon that suits your circumstances. This then dictates the type of equities we will select for the portfolio. E.g if I am an aggressive trader/investor looking for outright growth then I should be willing to accept greater volatility in my portfolio, therefore my portfolio may generally consist of high beta stocks.
The specific top down approach will consist of finding the right countries to invest in. So in today’s world we may take the view that GDP growth is likely to come in the East over the next few years. You can use publications from the IMF or World Bank to get an idea of projected growth forecasts in various countries in the East. Now logically if a country is experiencing GDP growth then there are likely to be opportunities present in that country in the form of Equity investments.
Once you’ve identified the countries you want exposure to then it’s a question of estimating growth forecasts for individual equities and the price you’re willing to pay for them. There are many approaches to valuation but the basics involve finding companies that are likely to sustain quality earnings over your trading/investment time horizon. Furthermore, you also have to forecast the likely return over a given period based on the information you have about the company, its sector and the economy it operates in.
This is important because what you want to do is separate two types of risk that are prevalent in each asset class. Systematic and Unsystematic risk. Systematic risk deals with potential risks affecting financial markets in general. Case in point 2008 when every single asset class got hammered due to the collapse of the MBS market. This type of risk is extremely difficult to control and cannot be done by diversification strategies alone. Interest Rates, FX Rates, Unemployment and GDP are examples of systematic risks that can affect equity prices. These are the factors that can be used in a Multi-factor approach to forecasting future returns.
Key thing here though is Multicollinearity. Basically if you use a Macro Model like this to aid you then it’s critical that the factors you choose have low or no correlation between them. If you have two or three factors that are correlated with each other then really you have one factor composed of two or three sub variables that are responsible for your returns forecast. Our aim really is to isolate as many uncorrelated forces that meaningfully impact the the returns for a security. The better we are at doing this the lower our error rate is likely to will be when forecasting returns.
One you have a forecasted growth rate and some idea on the price you are willing to pay, technical analysis can be used to optimise your entry price to eek out some extra return for lower relative risk.
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