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Are you prepared for a risk?

Chris Wicks takes an academic approach to investment with an emphasis on portfolio structure.

The investment markets are essentially 'efficient'. The efficient markets hypothesis holds that markets are full of people trying to make a profit by predicting future values of securities based on freely available information.

Many intelligent participants compete to trade at a profit. The price they strike in trading a share is the consensus of their opinions about the share's value.

Since the price is the same for everyone, so is the value. The price the market strikes is therefore based on available information about a share, everything the investors know that has happened in the past and everything they predict will happen.

In this sense, markets assemble and evaluate information so effectively that the price of a share is usually our best estimate of its intrinsic value.

Prices are not always perfectly correct, nor is that a condition for market efficiency.

The consensus view of investors can temporarily result in prices well above or well below a share's intrinsic value.

The only condition efficient markets require is that a disproportionate number of market participants do not consistently profit over others.

Since 'mispricings' occur in both directions and since managers over- and under-perform with random frequency when adjusted for risk and costs, markets seem to be efficient.

The optimum portfolio structure is based on, and supported by, a substantial body of academic research into the sources of investment risk and return which has reshaped portfolio theory and greatly improved understanding of the factors that drive performance.

There are three equity factors to consider: market - shares have higher expected returns than fixed interest; size - small company shares have higher expected returns than large company shares; price - lower priced 'value' shares have higher expected returns than higher-priced 'growth' shares.

The notion that equities behave differently from fixed interest is widely accepted. Within equities it has been found that differences in share returns are best explained by company size and price characteristics.

In the realm of fixed interest, two factors drive returns: maturity - longer-term instruments are riskier than shorter-term instruments; default - instruments of lower credit quality are riskier than instruments of higher credit quality.

Though these two factors characterise interest-sensitive investments, they do not have substantially stronger long-term expected returns.

Therefore fixed interest is best kept short in maturity and high in credit quality so risk exposure can be increased in the equity markets, where expected returns are higher.

One of the best-established methods of risk management in investing is diversification. The concept is simple: holding only one share in a portfolio makes you directly susceptible to its price changes. If its price plummets, so does your entire portfolio.

Hold two shares instead and, unless they both plummet, the portfolio is still afloat. The key to diversification is the age old adage "don't put all of your eggs in one basket".

The main point of diversification is to reduce risk rather than improve expected return.

For many European investors the MSCI Europe Index represents the first equity asset class in a diversified portfolio. Although this index is diversified in European companies, investors can benefit by adding further components.

Take, for example, a portfolio with just European shares, a portfolio that holds international shares and one that holds a third in both regions with a third in international bonds. The diversified portfolio has a substantially lower standard deviation - risk to you or I.

This is the power of diversification: the whole is greater than the sum of its parts.

Asset allocation is also extremely important for the investor.

Capital markets are composed of many classes of securities, including domestic and international stocks and bonds.

A group of securities with shared economic traits is commonly referred to as an asset class. There are several asset classes, all with average price movements that are distinct from one another. Investors can benefit by combining the different asset classes in a structured portfolio.

Investors should not only diversify across securities within an asset class, but also across asset classes themselves. This should include the full range of strategies: small and large stocks, domestic and international, value and core (growth), emerging countries, global bonds, real estate.

Because the asset classes play different roles in a portfolio, the whole is often greater than the sum of its parts.

Investors have the ability to achieve greater expected returns with lower standard deviations than they would in a less comprehensive approach.

However, because no two investors are alike, there is no single 'optimal' asset allocation. Each investor has his or her own risk tolerances, goals and circumstances that dictate the weightings in each asset class.

In general, the greater the proportion of stocks held, especially small cap and value stocks, the more 'aggressive' a taker of risk it is and greater long-term expected return.

Many investment managers either believe they can actively exploit 'mispricings' - traditional active management, or do nothing to add value over benchmarks - traditional index management.

A different approach combining broad diversification, low cost and reliable asset class exposure of passive strategies and adds value through engineering and trading.

Academic research has shown that the three-factor model on average explains about 96% of the variation of returns among fully diversified professional US investment plans.

Investing is therefore largely about deciding the extent your portfolio will participate in each of the three risk factors. In general, the greater the risk, the greater the expected return.

Chris Wicks is a director at N-Trust Limited.

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