Investing in shares – creating a portfolio

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For a new investor, the most challenging task is to determine the allocation of your money on different shares. If you are investing all your money in shares of one company, there is no need to worry about the most optimal portfolio. In real life situation, you may need to spread your risk by investing across several shares of different companies. Therefore, when you are investing in shares you need to master the art of creating a portfolio.

What to consider before creating a portfolio of shares

You may find it useful to read our post on investing for the first time before you proceed.

Understanding risk

As an investor, you need to understand the risk you are taking. Not all risks are worthy taking. Likewise, you can easily diversify other risks away without reducing your expected return.

There are two major categories of risk which are systematic risk (market risk) and non-systematic risk. Non-systematic risk can be reduced by diversifying your portfolio while systematic risk can not be eliminated through diversification. As an investor, your are rewarded for taking systematic risk.

Moreover, market risk is the risk that an investor will lose his/her money due to the conditions that affect the performance of the whole market (hence the name systematic risk). Examples of the factors that can cause systematic risk are political unrest, wars, natural disasters or interest rate changes or financial crises.

Non-systematic risk is the risk that is associated with a specific industry or company. The risk of an investor losing money when a company changes its management is an example of non-systematic risk.

Selecting the shares to invest in

There is no certain formula that you can use to select the companies you want to invest in. No one knows the future, we can only speculate and predict. We can base our prediction on the historical performance as well as the long term goals of the company.

Furthermore, the fact that one industry is doing well today does not guarantee that it will perform well in the future. For an investor targeting long term growth, it is crucial to keep on researching the performance of the companies he/she is interested in.

Understanding the company you want to invest in may give you a hint of whether its shares are undervalued or not. This will also show you the likelihood of positive changes of its share prices.

In addition, the risk of the shares may guide you on your selection process. It is worthy pointing out that highly volatile shares have a chance of achieving high returns. Therefore, if you are a risk taker, then such shares may be a good choice.

How to create a portfolio of shares

After selecting the list of companies to invest in, you may need to extract the historical prices of the shares. The historical data provides the historical performance of the companies. Share prices are highly sensitive to the company performances.

With the share price data, you can calculate the returns and risk of the selected shares. The returns of the assets are calculated as follows:

Or similarly,

You can use this formula to calculate daily, monthly and yearly returns. The next step is to calculate the average and the standard deviation (risk) of the returns for the different shares. This can be easily done in excel.

Portfolio optimization

After determining the average and risk of different shares, there is a need to determine the proportion to buy in each selected company. Portfolio optimization is the process of finding the best performing portfolio weights by either

• minimizing risk,
• maximizing returns or
• maximizing returns under the constraints of risk.

These optimal weights are used to determine the portfolio returns and risk. For a risk averse investors, the ideal weights are those that that minimize risk on a given selection of shares.

Practical example

Let us consider investing in Anglo-American (AGL), Implats (IMP) and Momentum Metropolitan (MTM) shares. We extract the historical data of the shares to determine the daily returns and risk of the three companies as follows:

The portfolio is optimized to get the weights given in the table below:

As a result, we notice that for equal weights, the daily portfolio return is 0.00257 with daily portfolio risk of 0.011915. The second portfolio of random weights is not optimal. Despite taking more risk (0.012557), the return (0.00176) is lower in comparison to a portfolio of equal weights.

Furthermore, the last four portfolios are all optimal. For a risk averse investor, the portfolio that minimizes risk (3rd portfolio) is the best. Note that on this portfolio, risk is very low (0.010558) in comparison to other portfolios.

For a risk taker, the ideal portfolio is the portfolio that maximizes returns (4th portfolio). This portfolio requires the investor to put all the money in IMP shares. The portfolio daily returns are high but there is a high risk.

In addition, the 5th portfolio maximize returns under the constrains of having a daily portfolio risk less than 0.02. The 6th portfolio minimize portfolio daily risk under the constrains of achieving daily portfolio return of 0.003. These two portfolios are ideal for those investors who have return and risk targets.

In conclusion, the risk profile of the investor will determine the portfolio of the investor. The portfolio selection will also depend on investor’s choice of shares. It is advisable to seek professional assistance on choosing the portfolio that addresses your investment needs. Some brokers provide that assistance at an additional cost.