Opinion – De Grão em Grão: How often do you evaluate your portfolio?

In our office, we have a monthly practice that all investors could adopt in their investments, the periodic evaluation of the optimal investment portfolio. This monthly assessment is relevant to analyze whether the investments in your portfolio are in line with the expected return and risk objective. I explain below the steps and how you can adopt it.

In the process of defining your investment portfolio, the first step is to define an investment policy with an objective of return and risk for the portfolio. Periodically, you need to assess whether the portfolio is in line with the given investment policy.

So I’m going to talk today about this periodic evaluation process. The frequency of this evaluation must be well defined so that there is discipline in its execution.

The minimum frequency would be annual. So, annually, you should set aside time to do it. In shorter-term valuations, care must be taken not to get carried away by market volatility.

The periodic evaluation is disregarded by most investors, who are more concerned with the purchase of the asset that will appreciate more in the short term. However, it is well known that strategic allocation is most responsible for the long-term performance of the portfolio.

The methodology we apply for the periodic evaluation of the portfolio can be broken down into four steps.

Step 1 – Scenario Assessment

Have you ever had an asset in your portfolio that went down in value and you didn’t know whether to sell, keep or increase your stake to the initial position?

This doubt arises precisely because of the absence of an economic and market scenario that guides the reason for having a position in the asset. An asset that made sense to have in one economic scenario may not do so in another.

For example, imagine that you invested in the stocks of retail companies because you believed in strong economic growth, low interest rates, and credit growth. These stocks went down and you were stuck in the uncertainty whether to sell or not. In fact, you should first assess whether the previous scenario is maintained or if in a new scenario, it would make sense to take these actions. Therefore, instead of focusing on the asset, one should first focus on the economic scenario.

In this scenario, you will establish your expectation for the main economic variables that affect the assets of your investment universe. For example, it should set expectations for national and accompanying economic growth, inflation, yield curves, earnings growth, exchange rates, and others.

For most investors, setting these expectations is an arduous task.

A suggestion for you to learn which economic variables to follow and how to set expectations for the scenario is to follow the open meetings of asset managers.

To participate in these meetings, simply register on the managers’ website and you will be informed about the times. They take place online. So anyone can follow along.

In these meetings, economists and managers expose their views on the scenario and how they transformed this scenario into investments. It’s a real class.

Step 2 – Analysis of which asset classes would perform better in the defined scenario and in what proportion

After defining the scenario, it is time to analyze how these variables influence asset classes and how they should behave.

You must think in an impartial way, that is, as if you had no investment and were going to build your portfolio from scratch.

With a scenario in place, you must set return and risk expectations for each of the asset classes. For example, foreign exchange, Brazilian stocks, US stocks, emerging market stocks, real estate funds in Brazil, REITs, fixed-rate fixed income, fixed income referenced to the IPCA, Selic, private credit and so on.

With this data and knowing the correlations between asset classes, you compose the portfolio in order to align the return and risk objective with that established in the determined investment policy.

Step 3 – Analysis of the performance of the current portfolio

You could imagine this step would be done earlier. However, it is important that it is carried out later so that the setting of the scenario and expectations about the asset classes is not influenced by the past performance of the assets.

For example, if the stock market has risen sharply in the previous period and you are winning, you may be tempted to project that it will continue to rise and you will create justifications in the previous steps for doing so.

The third step is essential to assess whether the current portfolio is in line with what was previously defined or if any changes are needed.

However, changing can always bring some kind of cost. So this is the last step.

Step 4 – Assess whether it pays to switch from the current portfolio to the revised one

One might think, if you took the trouble to define the best portfolio for the established scenario, why not change?

Portfolio changes can have some sort of cost, such as transaction costs or taxes.

There is also a range of fluctuation in the estimates. The returns on the asset classes defined in Steps 1 and 2 are an expectation, that is, formed by probabilities in scenarios. Therefore, they are not deterministic numbers and they cannot be different.

Thus, it is necessary to assess whether the return you will obtain from the exchange is sufficient to cover the transaction costs and the risks on the probabilities established in the scenario.

For this, it is important to calculate the correlation of the assets. Often the asset that you already have in your portfolio has a high positive correlation with another asset in the new portfolio. In this case, an exchange, eventually, can only bring costs.

Evaluating your portfolio in a disciplined way and with a defined process is important to correct possible deviations that the portfolio has in relation to the investment policy initially established.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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