Portfolio Construction and Management
As a leader in the organization, you care about the number of projects successfully completed per unit time. Yes, this is a measure anyone can game. All you need to do is make the projects smaller, and you have more projects completed per unit time. Projects that don’t successfully complete lead to emergency projects, which reduces your management effectiveness and your ability to provide value to the organization, as in Signs You Need to Manage the Project Portfolio.
When teams take a long time to complete projects, you don’t have enough flexibility to change what’s going on in the organization— to actually manage the project portfolio. This tutorial explains the Portfolio Management with best examples.
Be careful when measuring project completion time. It is just a surrogate measurement for what you really want to measure—a continuous value stream. A project is what you decide it is. Remember, customers don’t buy or use projects—they buy sets of running, tested features. If you really want to measure projects, go ahead. I won’t stop you.
It might help you see how short you can make your projects and be successful. But you can’t normalize projects against each other to compare their value to the organization. I find measuring projects makes managing the portfolio more complex than it has to be. Instead, I recommend you measure the time it takes a team to complete a set running, tested features, as you’ll see in the next section, so you can manage the project portfolio effectively.
If you’re stuck in a serial lifecycle such as phase-gate or waterfall and can’t measure running, tested features, consider changing your approach to product development. If you manage the portfolio, reviewing the progress made on running, tested features by your teams, you don’t need a serial lifecycle, because you don’t need the early milestones to attempt to gauge progress.
Using an agile life cycle provides the most information early, but even choosing an iterative lifecycle to try some prototypes at the beginning of a project, followed by building the product incrementally, will still provide you with more information than a serial lifecycle.
If you really can’t move to agile or incremental approaches for your projects, you will have to rely on the old, traditional measures, such as ROI. Read Developing Products in Half the Time: New Rules, New Tools or the financial measures section of Agile Estimating and Planning.
You will spend a huge amount of management time defining and gathering these measures. And, because you’re not using incremental or agile approaches, you won’t be able to adapt to what’s going on in the world. In reality, your measurements will not provide you with the information you need to manage the project portfolio. You will be guessing.
If you’re ready to take advantage of all the ways you can use the portfolio—to trade off between projects, to stop projects when they are done enough, and to schedule the next projects—you might need additional measurements to see whether the projects are returning some value. You’ll need some project and portfolio measurements.
In our opinion, there should be as many different portfolios as there are investors. Each investor is unique and, through his or her objectives, has a sensitivity to risk and losses and a time horizon all of his or her own. Thus, we favor an approach that allows tailor-made asset allocation for each client.
Modern Portfolio Theory According to Markowitz
Harry Markowitz was awarded the Nobel Prize in Economics in 1954 for his work, particularly his demonstration of the concepts of diversification and correlation. The analysis you are now reading would not have been possible without his research, but it must be said that for many years now his principles have constituted the basis of modern financial theory without anyone really seeking to question them.
Within the framework of modern portfolio theory, Markowitz designed a so-called efficient portfolio that minimizes risk for a given return thanks to diversification and low correlation between assets. Each security is described using two parameters: expected return and risk.
By combining different assets that are not perfectly correlated, risk can be reduced, even to the point of becoming lower than that of the least risky of securities. The lower the correlation, the more the portfolio's risk can be reduced.
The problem with this theory is that it is based on volatility as the only measure of risk. But, as we have already seen, volatility is not an appropriate measure of risk and the normal distribution is unsuited to stock market price fluctuations. Extreme events are much more common than a theoretical distribution would have us believe. Interestingly, Markowitz himself remarked that the bell curve wasn't necessarily the best way to measure risk. Furthermore, the number of calculations required is very high, especially in terms of correlations.
The correlation factor can also be criticized for the fact that in practice, all securities are positively correlated. Following the market corrections that occurred in 1987, 2001 or in late 2008, the proportion of a portfolio held in stocks was more relevant than the correlations between different stocks, because in a market that has begun a sharp correction phase, all stocks drop at once.
Nonetheless, it can be worthwhile using very weakly correlated stocks to decrease risk. Yes, but which risk? If we consider that stocks are inherently risky assets, the correlation criterion becomes less relevant. The variety of stocks held helps to diversify a portfolio, but is a portfolio made up essentially of stocks really less risky?
The concept of diversification, however, is important, as it helps reduce the specific risk that we talked about earlier. According to studies, the benefits of diversification apply from as little as 30 securities. At 60 securities, it is practically eliminated. International diversification is also an advantage, as is diversification between different asset classes.
Diversification certainly helps reduce specific risk, but it in no way eliminates market risk, which remains present no matter what. As we have seen, this market risk is not limited to volatility but incorporates a large number of underlying risks. We might even wonder if investors are really conscious of all the risks they are taking.
It is interesting to note that Warren Buffett recommends, on the contrary, concentrating your investments. In his view, “if you've found the right stock, why buy only a little?” When putting together a stock portfolio, he advises including no more than 10 different stocks. In his opinion, “diversification can increase your chances of subpar returns”.
Meanwhile, Peter Lynch says that “there's no point in diversifying into unknown firms, just for the sake of diversifying”.3 For small portfolios, he suggests holding between three and ten stocks.
Indeed, small positions don't add much value to a portfolio and once we've decided to invest in a particular sector or stock, the position should be substantial. We agree with Buffett on this point and believe that over-diversification can impact negatively on a portfolio's performance. Obviously, in the event of a market downturn, it is better to be diversified. But as we said earlier, a sharp correction will make all stocks fall, independently of their correlation and their diversification in a given portfolio.
For two reasons—use of the volatility criterion as a measure of risk and a large number of calculations required to determine an efficient portfolio—we believe that Markowitz's initial approach is somewhat outdated and that other paths should be explored.
Richard Michaud, in his criticism of mean-variance optimization, says that this “significantly overweights (underweights) those securities that have large (small) estimated returns, negative (positive) correlations and small (large) variances. These securities are, of course, the ones most likely to have large estimation errors.”
Before continuing our analysis, it would be useful to present the approach of Chief Investment Officer at Yale University David Swensen. He and his team manage the university's endowment fund of over 20 billion dollars. The annual performance of this institutional portfolio over the last 20 years has risen to nearly 16%.
David Swensen's approach
In light of the above criticisms, Swensen suggests adjusting the financial markets' historical data and then starting the optimization process. He suggests using a mean-variance optimization analysis with modified, forward-looking data and constraints in terms of maximum weighting, in order that no asset class dominates the portfolio.
Once the results have been obtained, he recommends respecting strategic allocation policies strictly through regular rebalancing. This approach may be appropriate for institutional management, but it doesn't necessarily suit private investors who generally have shorter investment time horizons.
The Capital Asset Pricing Model (CAPM)
According to Sharpe, if all investors are looking for efficient portfolios, they will all ultimately want the same one: the famous market portfolio. It's the market itself that would, in a manner of speaking, conduct Markowitz's fastidious calculations to determine this market portfolio.
For Sharpe, all investors should hold a risk-free asset and this market portfolio. The only difference between investors lies in the proportions held in these two positions.
This approach has the advantage of considerably reducing the number of calculations, and of pricing any individual security, by determining the expected return of an asset according to its risk, measured by beta. By analogy, a high beta means high volatility and therefore more risk. All that is required therefore is to make a global market forecast and to calculate the beta for each stock, which will ultimately determine the extent of the stock's movement compared to the market. This approach led to Sharpe's Capital Asset Pricing Model.
However, given that all the factors are estimated, especially the returns, it is hardly feasible to reach a precise result. The model relies on an estimate reached using other estimates, which must then be compared to a market price often determined in an irrational manner in inefficient markets. Consequently, we have a hard time understanding how the use of this approach can be justified for valuing securities and constructing a portfolio.
Moreover, besides the difficulty of knowing exactly which market or index is supposed to represent the market portfolio best, this approach pays no heed to the fact that each investor is unique, with different targets and perceptions in terms of risk.
Nonetheless, the idea of a market portfolio helped define passive management and, more importantly, allowed a new approach to portfolio construction to be developed, to which we will now turn.
We concluded in the first blog that beta was not an appropriate measure of risk. As such, any portfolio construction that relies on this concept should be rejected. There are “improved” variants of the CAPM that include other factors, such as the “multi-factor CAPM” or “Arbitrage Portfolio Theory”, but these models are based on the same concept and therefore should also be rejected.
The Minimum Variance Portfolio
Passive management involves investing in a market index or an instrument that replicates this index (a tracker fund for example) with a view to achieving a performance identical to the index. If the market is efficient and the CAPM holds, then the weights given by the market are supposed to be optimal. However, as we have already pointed out, index weighting by market capitalization does not necessarily attribute optimal weights to different securities. Therefore the market portfolio is not necessarily efficient.
In practice, it also appears that the observed market portfolio (ex-post) differs from the expected market portfolio (ex-ante) in terms of risk and return. But is there a portfolio that can deliver a higher performance than the index for a lower risk?
This portfolio is, therefore, an improved version of the market portfolio, thanks to both the choice of stocks and the weights assigned to them, which improve the composition of the benchmark index and, more importantly, its performance.
Some studies show that an equally weighted portfolio can do better than a minimum variance portfolio, but it is important to remember that the objective is to minimize variance by concentrating on risk management rather than on expected returns. Close attention should be paid to constraints regarding maximum weight, as well as the frequency with which positions are reviewed.
Unigestion, a pioneer of minimum variance portfolio construction and management, selects stocks within the original investment universe using various criteria and a whole series of filters (financial health, liquidity, specific risk). They believe the universe should include a sufficient number of stocks/sectors to guarantee proper portfolio diversification.
The aim is to pick stocks with the lowest volatility and little correlation between them. First, the minimum variance portfolio is defined using constrained optimization. This quantitative approach is then validated qualitatively by the management team. It also has the advantage of focusing solely on risk management, without incorporating expected return criteria.
Unigestion has specialized in stock management and is able to successfully outperform the market index over the long term with less volatility.
However, the minimum variance portfolio is subject to market fluctuations and produces negative performances during market corrections. Because of its lower volatility, these negative performances are not as bad as those of the market. This portfolio obviously participates in bull markets but to a lesser extent. Given these characteristics, it nonetheless manages to generate a better performance over time, demonstrating that it is always better to avoid or minimize losses, as we have stated several times.
In our opinion, given that index weighting is not always optimal, this approach is an attractive form of improved passive management, bordering on active management. However, the main disadvantage is that this portfolio is invested 100% in stocks, leaving little room for flexibility.
We also concluded in the first blog that VaR was not an appropriate measure of risk. As such, any portfolio construction that relies on this concept should also be rejected. However, VaR does have the advantage of focusing more on the possibility of losses, and therefore on the truly negative consequence of risk materializing (capital loss).
Before continuing our analysis and suggesting a new approach to portfolio construction, it is worth looking into how banks construct portfolios in practice.
In practice, the efficient frontier, beta or VaR concepts are used to construct and manage portfolios. Furthermore, funds practicing active management are often included in portfolios and, as Swensen notes, “as size is the enemy of performance, more established managers with greater funds under management tend to produce less eye-catching results”. J. Lerner of Harvard Business School and A. Schoar of MIT's Sloan School even assert that the more spectacular the growth, the more severe is the drop in performance.
In the framework of so-called benchmarked strategies, a market benchmark is used to measure performance against a market or a composite market index. When the management team achieves a positive performance higher than the benchmark, or if it manages to limit a drop to say −15% while the market has made a negative performance of −20%, the target of outperforming the benchmark is reached.
However, this strategy does not always ensure the market is outperformed, and as Swensen says regarding bonds and domestic stocks, “after deduction of all fees, the average manager produces market-like returns”. He recommends avoiding active management in markets regarded as efficient (bonds) or to undertake it with the utmost caution and realistic expectations. He sees fairly illiquid markets as offering more investment opportunities for active management.
As we indicated in the previous section, the returns offered by cash, or simply the inflation rate, are often regarded by investors as the benchmark. In addition, there is often a lack of flexibility in terms of investment in different asset classes, with the originally defined percentages being fixed or allowing few variations.
Furthermore, behavioral finance is not sufficiently taken into account. Investors tend to be conservative during bear markets and dynamic during bull periods. In other words, they are very sensitive to losses and always prefer to avoid them.
In our opinion, more consideration of the investor's benchmark (0%, inflation rate, money market rate, etc.) and more flexibility should be integrated into portfolio construction. Total flexibility (0–100%), or at least more flexibility within each asset class, should be envisaged. Finally, an asset class should be invested in according to its attractiveness at the given time.
Volatility as a measure of risk is still too often taken into account in portfolio construction. However, as we have said, stocks are risky assets, for which risk can be regarded as the decision to enter or exit the market (or a risky asset). There is a classification of the various risky assets, but an approach based on volatility no longer seems suitable.
Management profiles are sometimes too numerous and the management fee structure poorly adapted. In terms of management costs, management fees, which represent a certain percentage of the assets, are distinct from transaction fees related to the amount of the purchases and sales in the portfolio.
These fees diminish the portfolio's final performance. An “all in” fee is a more equitable solution for investors because a single rate applies regardless of the total number of transactions. Another interesting approach is to charge a management fee covering the minimum operational and administrative management costs, and performance-related fees when performance exceeds a certain level (the LIBOR, for example).
Finally, excessive use of investment funds often has the disadvantage of over-diversification, payment of fees on several levels and the possibility to exit only at NAV (net asset value).
With regard to bull and bear movements—periods of over- and under-performance of investment funds over time—it is better to use index or tracker funds that offer better flexibility (exit and entry at the market price), the possibility of placing stop-loss orders and, especially, lower management costs.
The Dollar-cost Averaging Approach
This investment method consists of investing the same amount at regular intervals over a long period, making it possible to buy in both market upswings and downturns and avoid market timing.
In other words, in a bear context, investors lower the average cost per share at each investment, ultimately reducing their average purchase cost. This approach is worthwhile for creating a position because it enables this to be done in several goes, thereby reducing the average acquisition price.
Besides the fees involved with these regular purchases, which can be especially significant for small amounts, investors must regularly have funds available and be able to consider a relatively long investment time horizon. However, for this investment period, they must be willing to endure fluctuations that may be very high and will affect their entire position—making the average purchase price secondary. Indeed, by following this approach, market exposure increases with each new investment.
As we mentioned earlier, it is better to avoid the stock market at certain times and invest at others. The minimum purchase price is when the market dips, and investors should then buy more, even in absolute terms, as subsequent purchases made at a higher price will just increase their average purchase price.
Moreover, depending on the desired degree of exposure to stocks, this approach cannot be used indefinitely, as the stock percentage may quickly be reached. Finally, buying a position is only one step, and it is just as important to know how to sell and take the profit according to the target return. We will simply retain the fact that a position can be created in several stages, but continued investment does not seem appropriate.
Our Portfolio Construction Method
We mentioned earlier that it is a good idea first of all to determine the maximum losses that investors are willing to suffer, i.e., to define their proportion of risky assets. In other words, investors must contemplate how much of their assets they can risk losing in the future if they decide to invest. This component may be expressed either as an amount of money or as a percentage of their portfolio. Then, depending on the attractiveness of the asset class at the time of analysis, investments will be made.
Interestingly, Zaker proposes a similar approach for hedge funds. During asset allocation, he suggests defining which share of the portfolio can be illiquid, which amounts to deciding on the share of hedge funds on the basis that this type of investment lacks liquidity. Moreover, depending on market conditions, some strategies will be more suitable than others, which underlines the fact that the attractiveness of an investment varies over time, and depends on the moment that we are performing the analysis.
We suggest taking things one step further by including an illiquid component (hedge fund component) within each asset class according to its strategy. Thus, a long-short equity fund should be accommodated in the equity component, and a convertible arbitrage fund in the bond component.
The observation period goes from 3 to 6 months, while the management horizon is 15 days. […]. The fund doesn't avoid risk but controls it.” Our management strategy promotes such flexibility while taking into account the observation and holding periods mentioned previously.
Basic Principles of Portfolio
Investors' portfolios should be constructed according to their specific objectives and needs, and obviously their risk profile, i.e., after having determined the share of their holdings they are prepared to risk.
The allocation between the various asset classes will then be carried out by combining several analyses. Next, depending on market conditions, the attractiveness of one or more asset classes will be determined. This analysis must be performed dynamically, so that changes in market conditions can be taken into account, and, more importantly, in an entirely flexible manner to allow for adaptation to these conditions.
This allocation is much more important than the diversification ensured within each asset class. In addition, negative or weak correlations have a positive effect on the portfolio, because they help reduce the portfolio's risk and improve its return. So the first step is deciding, for each asset class, whether or not it should be included. The next step is to make choices within the selected asset classes.
Finally, it is useful to include transaction costs, fees associated with the investment such as custodial fees, and ultimately tax, which may have a significant impact on performance. In terms of portfolio management, we should also bear in mind these simple rules:
always trade a small number of securities that you know well;
respect the existence of cycles (trends);
take advantage of a few opportunities a year.
Before presenting our approach, we would like to look at Peter Navarro's rules for investing.
Rules for Protecting your Capital
Navarro recommends the following 10 rules to help investors protect their capital and trade on the markets effectively.
a) Cut Your Losses
It is essential to know how to cut your losses when the situation deteriorates, in order to limit them and especially to reduce the investor's opportunity costs. It is better to sell a security, even for a small loss, and reinvest the capital in another security with better prospects, which can not only recover the original losses but generate gains.
b) Set Intelligent Stop Losses
It is also important to decide on the level of losses you are willing to accept and to set stop losses accordingly. You can use a mental stop loss, but you have to have the discipline to sell once the limit is passed. This solution does leave a little more time to evaluate the situation, but the investor has to follow the stock attentively every day. This type of order can also be set directly on the market at a defined level, but we recommend respecting the following rules:
leave enough room for the stock to fluctuate;
do not set stop losses near important technical levels (supports, resistances);
avoid round numbers, such as 10, 20 or 100.
c) Let Your Profits Run
Equally as important as knowing how to cut your losses is knowing how to let your profits run without liquidating too early. This isn't easy in practice, and setting a return target for the position holder will help.
d) Never, Ever, Let a Big Winner Become a Loser
To lock in profits, or at least most of them, the stop-loss price must be constantly redefined according to the stock price movement.
e) Never Average Down on a Loser
As the saying goes, don't catch a falling knife. Similarly, it is unwise to increase your capital on a stock that keeps losing value with the excuse that the price is going down. It's best to pick another stock with a better outlook.
f) Don't Churn your Portfolio
The number of trades should be limited. At times, when there is no defined market direction or too much uncertainty above its development, it can be wiser to do nothing.
g) Use Market Orders to Capture the Price Movement in a Trending Market
In a market with a defined trend, it's better to use market orders to avoid having to follow the market and modify your order after each unsuccessful attempt.
h) Use Limit Orders to Capture the Spread in a Trading Range Market Limit orders, on the other hand, can be used in a market with no clear trend.
i) Never Use a Market Order Before the Opening Bell or with a New IPO. As prices can swing wildly just after opening or before an Initial Public Offering (IPO), it is not advisable to set orders at these moments.
j) Choose the Right Broker
Depending on the prices and commissions offered, it can sometimes be necessary to change brokers.
The 12 Rules of Risk Management
Navarro also suggests following 12 basic rules in terms of risk management.
a) Watch the Macroeconomic Event Calendar Very Carefully
It is essential to keep up with the calendar of macroeconomic events, such as central bank decisions on interest rate levels or the publication of the price index, to minimize risks of potential reversals or excessive price fluctuations following these announcements.
The impact of a macroeconomic event will depend on the context in which the information is released and whether it will attract the market's attention. A rising unemployment rate during an economic boom will have less impact than during an economic slowdown or early recession.
b) When in Doubt, Go Flat
When macroeconomic signals are equivocal and the market direction is hard to ascertain, it is better to wait for more clarity and, for example, invest in money market instruments.
c) Beware the Earnings Announcement Trap
Before any transaction, it is crucial to consider the announcement period for quarterly corporate results. Companies announce their earnings at the end of each quarter, and depending on their fit with estimates, prices may fluctuate strongly.
A Wall Street adage says “buy the rumor, sell the news”. Indeed, a rumor of better-than-expected results can push the stock price up, driven first by traders, then by the general public jumping on the bandwagon. Some traders already start exiting at this point.
When the results announced are higher than the consensus estimate, the stock rises, even more, driven by the general public, but sometimes it drops sharply afterward because of another expected result which was not reached. Earnings can be lower, equal to or higher than expected, but it is important to differentiate between the consensus estimate and the so-called “whisper number”.
The consensus estimate is based on subjective judgments by analysts who are covering the stock and receive estimates from the company, which often tries to be cautious. This estimate is therefore biased, and can be circumvented by referring instead to the “whisper number”. This includes a much broader panel of opinions and provides a better basis for evaluating earnings.
The stock price may also fluctuate before the event so that once the announcement is made if it meets expectations, the price will remain steady.
d) Always Trade in Liquid Stocks
Adequate liquidity makes it possible to enter and exit a position very quickly, thereby reducing downside risk potentially suffered by the seller. Navarro recommends never trading a stock that has an average daily volume below 500 000 shares.
e) Trade Enough Volume
The weight of a position in a portfolio will depend on each investor, who has to determine the losses he or she is willing to undergo, but it should not exceed 10% of invested capital or 20% at the most.
f) Make Sure your Trades are not Highly Correlated
It is important to ensure diversification between different weakly correlated industries to minimize the portfolio's risk. Several highly correlated positions concentrate risk.
g) Match Price Volatility to your Risk
Although Navarro associates the level of risk with the level of volatility, this is mainly to suggest placing stop-loss orders with regard to this volatility so as not set them too close to a stock's normal margin of fluctuation.
h) Manage your Entry and Exit Risk
It is often better to buy a position in several goes, which gives time for the expected direction to be confirmed. It is also wise to book your profits in several goes, to profit from a possible market rise.
i) Beware of Trading on Margin
When using leverage, it is essential to place stop loss orders to limit losses and to determine acceptable losses based on capital that is really available, i.e., not borrowed.
j) Analyze your Trades
It is crucial to be able to analyze your trades, especially your losers, so as not to repeat the same errors twice (market order before the opening bell, stop loss not set or set too close to the price, stock bought before an earnings announcement or some macroeconomic news, etc.).
k) Do your Research
Before each trade, you have to do your homework. First, you need to be familiar with the different industries, their leaders and followers. Then it's important to identify how macroeconomic events (according to the calendar) affect the stocks while bearing in mind their technical characteristics (volumes, spreads, fluctuation margins, moving averages, etc.). Finally, a fundamental analysis should be carried out.
l) Ignore Hot Tips and Other Free Advice
Navarro recommends ignoring analysts—who rarely advise selling the stock because of the eternal conflict of interest between the analyst and their employer —and friends' advice, but to make decisions based on your own judgment.
The Portfolio Construction Process
The following approach can ultimately be summarised as a process in nine steps, which should be reviewed regularly (at least once a year).
The Investor's Life Objectives
The first step is to determine the investor's goals, taking into account not only his or her professional and personal projects but also his or her cultural, social and religious background.
The Investor's Life Cycle and Investment Time Horizon
The second step is to identify the investor's current stage of life:
accumulation (asset accumulation and ability to generate future income);
consolidation (income exceeds spending);
spending (use of income and possible consumption of capital);
Then, depending on the investor's age and need for liquidity, an investment time horizon can also be determined.
Choosing a Reference Currency
This step simply involves defining a reference currency according to the investor's country of residence, expenditure, and income. The portfolio's performance will be assessed in this currency.
Evaluating the Risk Profile
First, this means identifying the investor's ability to take risks, i.e., defining his or her financial limits according to his or her various commitments, available assets, and liquidity needs. In other words, it is necessary to conduct a personal assessment like a balance sheet (assets versus liabilities).
Then an evaluation is required to see if the investor is risk averse (to losses) or if, on the contrary, he or she likes taking risks when investing, within his or her financial limits. This means finding out if the investor is a “player” or instead looking for more certain returns. The advisor plays a key role here; it is he or she who has to determine this sensitivity to risk.
Finally, it will be necessary to ensure that the investor is conscious of the risk taken when making investment decisions. Indeed, we have seen that depending on their level of experience and the strength of their psychological biases, investors can react irrationally, and therefore under- or overestimate the risks taken.
According to these three aspects, it will be possible to qualify the investor as more conservative, moderate (balanced) or dynamic. In practice, banks often use questionnaires that aim to define a risk profile based on these three aspects, which will help determine the asset allocation.
As such, it is interesting to note the approach developed by Bhfs (Behavioural Finance Solution) to evaluate investors' risk profiles and suggest the asset allocation. We suggest comparing this allocation with the strategic allocation resulting from our process, as in our opinion, adjustments and additional discussions are always necessary.
Estimating a Return Target
An expected return estimate can also be established. This return target should then be compared regularly with the actual return resulting from the chosen portfolio construction and the decisions made. The idea, in a way, is to set the investor's individual benchmark. Investors may also mention a benchmark at which they would gain personal satisfaction from their investments.
It must be highlighted that this return target should not be used as the basis for constructing the portfolio. Our approach does not concentrate on returns, which are difficult to anticipate, but rather on managing the risks that make up the portfolio.
Investors may first express this target as an amount of money, which often corresponds to their spending or cash requirements. Sometimes, investors aim for a certain level of income at retirement age. The practical example at the end of this blog will serve to illustrate this. An expected rate of return may also be mentioned, and this usually is based on average historical returns for the different asset classes.
However, the target indicated must be realistic, considering interest rate levels and market conditions. Furthermore, historical returns should be treated with caution, as at best they can only help formulate estimates for uncertain future returns. As we noted earlier, we favor an approach based on risk management over one based on return estimates.
Furthermore, the desired return must correspond to both the available capital and the investor's risk profile. Any inconsistencies must, without fail, be identified at this stage of the analysis.
Finally, as we noted, to begin with, the desired return must obviously be positive and, if possible, higher than the average inflation rate in order to preserve the investor's real wealth over time. In our opinion, the rate indicated should be adjusted for inflation, unless the investor has already incorporated this into his or her target. Furthermore, net return—that is return after tax—should ideally be taken into account.
The Investor's Tax Rate
Next, the rate of income and capital gains taxes should be taken into account to define the investment universe more precisely. For example, in a context of high-income tax and no capital gains tax, low dividend stocks with high growth potential should be favored for the stock component.
Determining the Proportion of Risky Assets
The next step involves deciding on the share of risky assets that the investor can hold in the portfolio, given his or her financial limits and ability to take risks. In other words, investors have to decide how much of their capital they are willing to risk and, in the worst-case scenario, lose completely.
However, the degree of capital loss can be distributed and qualified. For example, an investor may accept to lose 10% of his or her initial capital entirely and to lose a large proportion (50%) of 20% of his or her capital, instead of simply asserting a willingness to “risk” 30% of the total capital.
Once this proportion has been established, it should be distributed between the different categories of risk that we defined earlier. This step makes it possible to set the upper limits of exposure to each asset class.
Evaluating the Expected Degree of Liquidity (Share of Illiquid Assets)
The investor should also define the required speed at which assets can be realized, which will help determine whether less liquid assets can be included in the portfolio. This proportion will designate the investor's potential exposure to hedge funds. If he or she accepts this exposure, the investor will need to choose one or more investment strategies, which will be included in the corresponding asset class as an alternative strategy in that class.
Portfolio Construction and Management
We stated early on that future returns are hard to predict, and estimates of the different probabilities associated with these returns are hard to make. Consequently, any portfolio construction method that relies on these criteria is likely to give random or uncertain results; it is difficult to obtain a reliable, precise result using estimates.
Portfolio management involves managing the various risks that make up the portfolio, by deciding whether or not to be exposed to a particular asset class. Portfolios should be constructed using the same reasoning: guided by risk constraints and not expected returns. We believe that managers should not manage expected returns but risks, and this is how they create added value. They can do this using the framework we are about to define.
a) Strategic Allocation and Type of Management
Based on the investor's risk profile, the final step of the process is to determine the portfolio's strategic allocation, i.e., to define a targeted distribution of capital between the different asset classes. As Swensen points out, “policy asset allocation dominates portfolio returns”.
Depending on the investor's profile, some asset classes will be excluded and others favored.
In terms of weighting, it is possible to define fixed weights. However, we recommend more flexibility within each class and avoiding an excessively narrow range of fluctuation, to ensure the greatest possible flexibility of investment choices.
We suggest defining first of all a maximum proportion per asset class, according to the type of risk profile. A maximum weight per position can also be defined at this stage (for example, a maximum of 5% per bond or 2% in an individual stock). As Swensen notes, “committing more than 25 percent or 30 percent to an asset class poses the danger of overconcentration”.8 So we suggest also defining a limit by category.
A minimum weight for each of the asset classes should also be set. The degree of fluctuation, which will allow the lower limit to be set, will ultimately depend on the degree of freedom that the investor wants to have or to allow his or her manager, as well as the desired magnitude within each asset class. In other words, it is important to decide if an entry into or exit from an asset class should be total or partial, and therefore if the investor wants to maintain a minimum exposure per asset class.
To refer again to Swensen, he says that “committing less than 5 percent or 10 percent of a fund to a particular investment makes little sense; the small allocation holds no potential to influence overall portfolio results”. So, once the decision to invest has been made, we suggest an investment of at least 3–5% in an asset class so that it can have an impact on the portfolio's final return.
The investor's degree of conviction about the ability to apply this approach will, in our opinion, define this lower limit. For example, investors with a weak conviction will prefer a bigger “fixed” component and a smaller “flexible” component. Conversely, investors whose conviction is strong will allow a much wider margin for fluctuation so that they can achieve optimal positioning in relation to market conditions.
We suggest first defining a maximum weight per asset class, and possibly per individual position. An exposure of 75% should be the general maximum limit for an asset class. Individual positions ideally should not exceed 10%. It is obviously possible to set lower limits (5% maximum per individual position, for example).
The minimum weight will depend on the minimum degree of exposure sought and on the desired degree of flexibility within the asset class. The limit may be 0%, but once a decision to invest has been made, we believe that an investment should represent at least 3–5%. Next, the investor needs to determine the type of management he or she prefers for each asset class, namely passive or active management.
Passive management seeks to replicate the performance of a benchmark index; index management (using tracker funds or ETFs) is the most common form. This offers enough diversification, good liquidity and helps achieves a performance consistent with the underlying, “neither more nor less”, with low management fees. However, there is a risk of concentration, as market capitalization weighting of indexes can sometimes lead to a significant concentration of large-cap stocks.
Conversely, active management aims for a better performance than the benchmark index by making specific bets on the stocks that make up the index and offers greater performance potential (stock picking in equity funds, for example). Besides the risk of under-performance and the risk related to the manager's decisions, the fees entailed by this type of strategy are higher.
We suggest evaluating, for each asset class, the opportunities for outperformance, i.e., the degree of efficiency of the class in question.
If these opportunities are weak, as is usually the case for bonds, passive management using tracker funds or ETFs should be favored.
If, on the other hand, these opportunities are more common or significant, such as for stocks (depending on the region in question) or less liquid markets, then active management is better. A combination of passive and active management is entirely possible.
In the classic, so-called “core-satellite” approach, passive management of the core component is combined with active management of the satellite component.
Some, like the Wegelin bank,10 takes things further for the core component by making a selection within the passive section aimed at eliminating certain securities from the benchmark index while maintaining sufficient diversification. Various criteria, such as historical earnings and free cash flow or the return on equity, are used to make these choices, but the end result should stay close to the reference index.
The minimum variance portfolio, as it is constructed and managed by Unigestion, discussed earlier, adopts a sort of improved passive management approach. The performance of such a portfolio is practically identical to its benchmark index, but with less volatility, which means it can outperform the benchmark in the long term. Thanks to their selection of stocks within the original investment universe and different weightings, they are able to determine a better allocation in terms of risk.
We readily recommend improved passive management in order to achieve a more homogeneous exposure to a market, and to reject stocks that are “only” in an index because of their large capitalisation—which are excessively weighted in the index—or securities that we don't want to hold in the portfolio temporarily or at all.
In terms of portfolio construction, it is also possible in a given asset class to define a minimum investment for the “core” component—held, for example, in a tracker fund (market index, improved or not)—and to allow a certain margin of fluctuation for the “satellite” component, which will constitute the active part of this class. The investor can then either increase exposure to the tracker fund, or pick individual stocks or favor certain sectors, but can under no circumstances go below the minimum threshold.
We could even imagine situations where tactical decisions are no longer made directly in relation to the basic strategic allocation, but delegated to the different managers in the active component. A strategic allocation is therefore defined for each asset class, with a part managed passively and another part managed actively.
Once the decisions are made regarding active and passive management, the investor must also decide on the level of delegation he or she wishes to allow. Indeed, besides the resources and time necessary for all these analyses, investors have to reflect on whether they have the skills necessary to manage their portfolio.
If their answer is yes, they can manage the portfolio themselves according to the investment model presented here. Otherwise, we sincerely advise delegating this management to a professional (manager).
Note also that investors or managers themselves tend occasionally to manage a portfolio more conservatively and take fewer risks than necessary. Past experiences of financial crises and sharp market corrections, which encourage increased caution, can lead to a conservative bias. The use of objective criteria and keeping “emotions” at arm's length help limit this bias.
In the end, the upper and lower limits for each asset class will be defined depending on the risk profile. management of the portfolio will, therefore, be governed by these limits. The different weights assigned within each asset class will depend specifically on management choices and the attractiveness of each asset class at the time of analysis. For each class, passive (improved or not) or active management will be informed by diversification requirements and opportunities for outperformance.
For stocks, we recommend adopting a more detailed approach that includes the various industries and sectors we described earlier, and the main geographical regions. Within this asset class, defined by the upper and lower limits, managers will make specific investments according to their view of the cycles, and choose the industries and sectors they believe to be positioned the best.
For bonds, once the level of credit quality has been defined, the choice of different issues will depend mainly on the desired duration and therefore on the expected movement of interest rates. For real estate, we recommend first favoring investments in the country of the investor's reference currency, then looking at foreign currency investments. It will, therefore, be necessary to decide on the regions or countries to favor.
These considerations on the incorporation and management of different asset classes have brought us to the point where we can address tactical allocation.
b) Tactical Allocation
Once the strategic allocation has been determined, the various tactical weights must be chosen according to the attractiveness of each asset class, macroeconomic and psychological factors and also the results of fundamental and technical analyses.
An overall market analysis should, therefore, be carried out to determine the asset classes to favor in constructing the portfolio, according to the set margins of fluctuation. While selecting asset classes, we suggest constantly asking the following question: “If I had the cash right now, what would I invest in?”
Our approach stops short of market timing, which aims to anticipate market movements in order to position investments optimally. Use of the multi-force approach does not seek to forecast market movements, but rather to determine, on the basis of current conditions, whether or not it is appropriate to invest or remain in the market. This analysis should be carried out on a regular basis, ideally weekly, and at the very least monthly.
Going back to our earlier barbecue example, market timing seeks to advise our sausage-lover whether or not he should go to the butchers on Monday in anticipation of the weather we're going to have at the weekend. Our approach, on the other hand, aims to help our friend do his shopping on Saturday according to the weather outside at the time he has to make his decision.
Swensen recommends avoiding market timing, which tends to weaken portfolio performance. For institutional portfolio management, where the time horizon is very long, much longer than that of private investors, management should indeed respect the basic strategic allocation, rebalanced regularly to maintain the chosen proportions.
However, for private investors whose time horizon is usually shorter and whose objectives change more quickly, a more flexible approach should be applied. We asserted earlier that this process is not focused on expected returns but on managing the various risks that make up the portfolio. Any element of forecasting should therefore also be rejected, to focus on current conditions.
i) Choice of Investments
Once a particular asset class has been retained, investment choices must be made within the asset class using the top-down approach, which means deciding first on a region and sector and then on an individual security.
As we indicated earlier, we recommend following a core-satellite management strategy by building a core of, for example, index funds, and then making a few bets on individual stocks.
The index fund used in the core component should be sufficiently diversified and should faithfully represent the movement of the market the investors wish to be exposed to. To avoid excessive concentration in a particular sector, or to avoid exposure to certain stocks, it is possible to adapt the composition of the benchmark index by eliminating stocks that don't meet certain criteria or that represent too great a weight in the index. So it can be wise to carry out some stock selection.
In terms of the form of investment in individual stocks, structured products can also be used depending on the outlook. Instead of buying a stock on the market, buying an option, a reverse convertible, a capital protected product or a maximum-return product in a set fluctuation range can also be considered. In this way, real exposure to a market or sector can be modified.
In terms of individual stock picking, it is worth mentioning an observation of Jesse Livermore's, a trader who wrote his memoirs of the early 1900s. In a bear market most stocks fall, and in a bull market, most rise. However, the average investor doesn't want to be told whether it's a bull or bear market but prefers to hear which particular stock to buy or sell.
He wants to have something for nothing, doesn't want to work and doesn't even want to bother thinking about it. It's certainly easier to think in terms of individual stocks but, above all, it's the general market movements that are worth studying, as they are what make the difference.
Finally, in terms of stock selection, it can be worth determining an observation period (six-twelve months, for example) and a holding period (three-six months, for example).
We believe it is better to define trends and use index funds accordingly, with a few bets on individual stocks. It is not these few positions that will make the difference, but rather the general market movement or movement of a particular sector.
ii) Foreign Currency Management
Foreign currency exposure must also be managed according to currency forecasts, although their development is very hard to predict in practice. As Swensen notes, “At more than 20 to 25 percent of portfolio assets, the currency exposure constitutes a source of incremental risk, suggesting consideration of some corrective action.”
In our opinion, analyzing the outlook of the investment currency is crucial. Indeed, as we mentioned before, short-term fluctuations can be very violent and affect the portfolio's total performance. The investor's or manager's degree of conviction will essentially determine the level of currency risk hedging.
Technical analysis is perhaps the most useful tool for determining the outlook for exchange rates. Some use the notions of absolute and relative purchasing power parity (PPP) to determine the expected currency movements. Absolute PPP: The exchange rate between two currencies equals the ratio of the two countries' price level of a fixed basket of goods and services.
Relative PPP: The expected rate of depreciation of the local currency is determined by the difference between domestic inflation and foreign inflation. Empirically, it has been observed that the currencies of countries with high inflation depreciate. The inflation rate differential between two countries may indeed play a role in exchange rate movements.
For example, if inflation is stronger inside the country than outside, domestic products become more expensive and economic agents will tend to look towards foreign markets (increasing imports), while foreign agents will buy fewer domestic products (reducing exports).
The country with the higher inflation rate will see its currency pushed down in order to conserve purchasing power parity. This variation in exchange rate lets domestic prices adjust so that the values exchanged in goods, services and assets are perpetually equalized.
Furthermore, note that capital tends to be invested in the currencies of countries offering the most advantageous compensation. These inflows can lead to an increase in demand for the currency and therefore an increase in its price.
iii) Rebalancing Rules
When holdings invested in an asset class remain within the acceptable range of fluctuation, no particular decisions are required. However, when the maximum limit is exceeded, the portfolio needs to be reconfigured according to the established rebalancing rules.
First, we might consider simply reducing the inflated component enough to bring exposure to the asset class back down to the maximum limit. Another option is to pull right back to the minimum level of exposure, or to an intermediate level. Ultimately, the choice will be linked to the attractiveness of the asset class at the time the threshold is crossed and to its future prospects.
Depending on market conditions, it could be better either to maintain a maximum exposure or, on the contrary, to book the profits and favor a more cautious approach for the future by reducing exposure to a lower threshold. Proceeds from the sale can be allocated between the other asset classes, or to one class in particular. Independently of the final thresholds chosen, it is essential to set precise rebalancing rules and to apply them rigorously in managing the portfolio.
c) Comparison of Actual Returns with Target Returns
The process that we have described is dynamic. Consequently, the expected return target should be compared regularly with the actual return resulting from the chosen portfolio construction and the decisions put into effect. We often tend to assess portfolios on an annual basis. It is entirely possible to modify the observation period by setting, for example, a monthly or quarterly comparison, with rates adjusted accordingly.
If the actual return deviates from the expected return, explanations must be sought using recent data, to determine whether the difference is due to:
an unrealistic target;
poor tactical allocation choices (under- or over-weighting of one or more asset classes);
poor basic strategic allocation that can never or rarely generate the expected return;
poor application of the model;
We also recommend performing this analysis when the actual return is close to or higher than the expected return target.
A Practical Example of Portfolio Construction
To conclude this blog, we will illustrate our reasoning with a practical example. Mr. Dupont, aged 45, has savings amounting to 750 000 euros, to which can be added the proceeds from the sale of his magnificent yacht that he recently sold for 50 000 euros and an account with 250 000 euros invested in the short-term deposit. In terms of investment, he is willing to grant considerable flexibility to his manager.
Under his savings plan (interest rate set at 2%), he can expect to have a sum of 1 470 000 euros at retirement age, which would provide him with an annual income of nearly 90 000 euros for 20 years.
He doesn't want to touch the 750 000 euros and hopes to constitute enough capital to live comfortably after 65. He says he is willing to “risk” the 250 000 euros but only 100 000 euros can be risked “in full”. The 50 000 euros will soon be spent, as he is intending to buy a new car.
Mr. Dupont is still working and has no major expenses. He is in perfect health and expects to live to 85. According to his estimates, and taking into account his various commitments (particularly his mortgage), he hopes for an annual income after the retirement of about 120 000 euros.
Mr. Dupont pays wealth tax. He is taxed on both capital gains and income. Liquidity is very important to him, especially if he is faced with unexpected expenses. Mr. Dupont lives in France but spends a lot of time in Verbier (Switzerland) where he owns a chalet bought some time ago by his parents. In winter, he goes there almost every weekend, and he stays there for at least a month each summer (about two months a year in total).
In view of these details, Mr. Dupont's profile seems fairly conservative and his ability to take risks is limited. With his fortune of 1 000 000 euros (750 000 in savings and 250 000 from his account) and the sum he is willing to risk, we can consider that 25% can be invested in risky assets, but only 10% in really risky assets. In terms of reference currency, we can consider the euro as the reference currency, but with a possible exposure in Swiss francs of 15% to 20% (2/12) to cover his need for cash in Switzerland.
As for expected returns, Mr. Dupont has indicated that he would like an annual income of 120 000 euros, but it is important to make a distinction between the capital made up of savings and the capital he intends to invest to generate additional income. In view of the desired annual income of 120 000 euros and the income generated by savings (90 000 euros), the additional amount required is 30 000 euros. At this stage, two fairly complicated calculations need to be made.
Firstly, we need to determine the amount of capital required at retirement age in order to provide the additional annual income for a certain number of years. Note that after each payment, the remaining capital generates a return. For our example, this amounts to calculating the present value of capital that our investor will need at retirement age in order to earn an additional income of 30 000 euros a year for a period that we will set at 20 years (with a life expectancy of 85 and retirement at 65).
Using the formula for discounting annuities over a period of 20 years and a rate of 2%, we arrive at the sum of 490 543 euros that will be required at 65 to allow for 20 annuities of 30 000 to be paid for 20 years. where k = discount rate and n = number of years.
Secondly, now that we know the capital required at age 65, we need to calculate the amount of the annual installments to be paid from now until retirement age to build up this capital, also taking into account an annual return on this capital being accumulated and potentially accumulated. For our example, given Mr. Dupont's current age, these installments will be paid over a 20-year period. To simplify things, we can deduct the 250 000 from the 490 543 at this point. We will leave the 50 000 euros for Mr. Dupont's cash needs.
This time, using the future value formula over 20 years and a rate of 2%, we arrive at an annuity of 9900 euros. This is the sum that Mr. Dupont will have to set aside each year in order to constitute a sum of 240 543 euros in 20 years' time, or by the age of 65. Thus, at 65 he will have the total amount of 490 543 required.
where k = discount rate and n = number of years.
Besides the length of the payment period and life expectancy, the really decisive parameter is the discount rate. We suggest using a fairly conservative rate of 2%, or 3% at the most. Finally, by dividing the annual sum to be generated by the capital available for investment, we obtain the target rate of return. Given the available sum of 250 000 euros and an expected revenue of 9900 per year, the return target is 3.96%. This is a nominal rate and the annual income indicated does not include taxes.
In terms of the rate of return, the real rate can be obtained by adding the inflation rate, but we are considering here that our rate covers an average inflation rate of 2–3%, so will not need adjusting.
However, in terms of taxes, we recommend considering the amount obtained after taxes. Therefore, the gross income needs to be recalculated so we can then infer a new target rate of return. Ideally, for the annual amount generated by investments, the capital gains component should be distinguished from the income component, so the corresponding tax rates can be applied. The target return arrived at, whether gross or net of taxes, should be regularly compared to the portfolio's actual return.
In terms of strategic allocation, we will only consider asset classes with low to moderate risk. As Mr. Dupont is happy to grant considerable flexibility in terms of investments, we can allow for almost total fluctuation within asset classes. Looking first at money market funds (or fiduciary deposits) and government bonds, the entire portfolio can be invested in these classes, however with a minimum exposure of 15% to 20%. For corporate bonds, the minimum is set at 15% with a maximum of 35%. These three holdings represent the “fixed” 50% of the portfolio, with the manager able either to increase these weights or invest in other asset classes.
It is possible to incorporate up to 5% real estate, or commodities/precious metals up to 3%.
In terms of equity, the proportion can vary from 0% to 25%, which is the limit “indicated” by Mr. Dupont. However, for an exposure of 25% to risky assets, we need to include indirect real estate, stocks and commodities/precious metals. In our opinion, if these three holdings are present at any one time, exposure to stocks should not represent more than 17% or 20%. Finally, considering Mr. Dupont's requirement for liquidity, hedge fund investments are unsuitable. On this basis, we could propose the following strategic allocation.
The attractiveness of the Different Asset Classes
Now we can examine the attractiveness of each asset class. The method of portfolio construction we propose combines the following four approaches based on:
trends (technical analysis);
The idea is to identify the forces that are likely to push prices up or down. The resulting force should give us the direction of the market and therefore help us decide on the attractiveness of that class.
In the event of a bull market, the decision to invest or hold a position is the most profitable. If investors decide to exit the market or to stay in cash, they will obviously not participate in the rise, but the most they will have lost is an investment opportunity.
In a bear market, the decision to hold a position or enter the market clearly leads to the worst possible situations, as investors will make a capital loss. However, if they decide to exit the market or to stay in cash, they are making a good choice that will preserve their capital.
An analysis using the four forces will allow the market movement to be identified. Then, according to the margins of exposure allowed for each asset class (minimum/maximum exposure), investors will have to decide whether or not they want to invest and in which proportions. The answer to this last question will depend on their personal experience, their knowledge, and analytical abilities, as well as their conviction about the market.
Before reviewing the four forces, we would like to go back over the attractiveness of each asset class for investors. We should reiterate that their incorporation into the portfolio must depend on their attractiveness at the time of analysis, and should fit within the framework defined by the strategic allocation.
Money Market Investments
This asset class—the least risky—usually represents a significant part of conservative portfolios. It also includes government bonds with a maturity of fewer than 12 months. Depending on the configuration of the portfolio, a fixed proportion of money market instruments may be necessary. However, because of their low real return, this asset class should be limited in every portfolio.
The return from a money market investment will essentially depend on the market interest rates and the rate of inflation. If inflation is high and the nominal rate is low, the real rate (nominal rate minus inflation rate) will be low, which may lead investors to consider other asset classes to prevent inflation “eating up” their capital over time.
As such, it is important first of all to compare the money market rates with the rate of inflation to determine whether the investment will at least cover inflation. Then it is useful to compare these rates with the returns of high-grade government and corporate bonds.
If the money market investment is considered worthwhile, the counterparty and maturities should then be carefully selected according to the investor's need for liquidity and the outlook for interest rates according to current and expected inflation. When using our model, the most important factors to examine are the various forces acting on interest rates.
Bonds should be incorporated into a portfolio according to the attractiveness of this asset class at the time of analysis, but their integration also depends on the investor's need for regular income to be generated over time. They usually represent a significant proportion of conservative portfolios.
Generally, the interest rates at longer maturities should be considered for bonds. These depend on the markets' ability to control inflation and are also influenced by the future financing needs and capacities of public and private agents.
Bonds are selected according to the issue's rating, yield to maturity and the maturity in question or, more precisely, the duration, which depends on expectations for interest rate movements. So, it is best to be positioned at the point on the yield curve that will be the least sensitive to interest rate variations. Interest rate developments and the control of inflation should be analyzed.
If interest rates are expected to rise, it is better to buy short-term bonds which are less sensitive to interest rate variations due to their low duration. Conversely, when interest rates are expected to fall, long-term bonds should be favored. The “exact” positioning in terms of maturity will depend on the expected evolution of the yield curve (flat, normal or inverted yield curve).
If fairly high inflation is expected, which portends rising interest rates, investors may decide to stay in cash or to choose short-term bonds. However, if they are very keen for regular income, by necessity perhaps, they can use inflation-indexed bonds to guard against the negative effect of a rates hike on prices.
It is also useful to examine the difference between government and corporate bonds to determine both the attractiveness of the latter and, especially, the overall economic situation. Indeed, this gap increases during a recession and decreases in periods of economic growth. Sovereign bonds, because of their usually modest returns and their negative sensitivity to inflation, should only make up a limited proportion of a portfolio.
The multi-forces model can be used to determine the various forces that will influence the price of bonds. However, the use of this approach is limited when the investment is held to maturity. In this case, investors seek simply to block a return over a given period, to earn coupons and recover the invested capital at the moment of final redemption. However, it is useful to be aware of the factors that influence bond prices.
As two independent analysts justly note, “investors should, therefore, base their expectations of gain on earnings growth”. When buying stocks, investors are above all buying economic growth, in the expectation of future earnings that the company will generate. They want to participate in the resulting creation of wealth.
In addition, because of their higher historical returns than those of other asset classes, stocks usually provide good protection against inflation. However, investors must accept the fact that they are investing in risky assets in absolute terms and may potentially suffer losses.
This asset class is essentially considered in order to generate higher capital growth, as limiting a portfolio to money market and bond investments may prove insufficient to cover average inflation. However, as we pointed out earlier, there are times at which it is desirable to invest in stocks and other times where it is wise to avoid this asset class.
We favor the use of a so-called top-down approach, which involves studying the major macro-indicators, firstly, to determine the general trend and the attractiveness of the asset class. Secondly, the best-positioned market sectors or industry groups should be selected, then finally the individual stocks from within those groups that are the most attractive in their industry.
Then, it is best to follow the so-called core-satellite approach, with more or less flexibility for each of these two components (definition of upper and lower thresholds within each part). This involves, for example, using an index fund (the core part under passive management—improved or not) and making specific bets on certain companies (the satellite part under active management).
The use of stop-loss orders is recommended for protection from downside risk, as is placing sell limit orders which can be useful for booking profits in the event of a rise, according to a return target set at the time of purchase.
It can be advantageous to use capital protected products, which are more consistent with investors' loss aversion; investors find losses more painful than they find gains satisfying. It can, therefore, be preferable to participate in market upswings while benefiting from capital protection at maturity. The use of options is also possible depending on the scenario expected for a position.
For the approach we propose, a detailed analysis of the four forces is essential in order to determine the resulting force that will push the stock market either up or down.
Direct real estate usually offers a low correlation with the other asset classes, especially stocks, with a return that is often more stable over time. Conversely, indirect or securitized real estate has a high correlation with stocks and can undergo large fluctuations in the markets.
In practice, it is advisable to invest between 15 and 20% in direct real estate and about 5 or 10% in securitized real estate, through a property fund or index, for example. For this analysis, we have decided only to consider indirect real estate.
The attractiveness of this asset class depends essentially on the level of supply and demand for real estate in a particular geographical region and for a particular type of real estate (residential or commercial). Demographic factors should also be taken into account as they stimulate both supply and demand. Interest rate levels also influence the value of real estate.
Because each property market has specific characteristics, a given market must be analyzed with the utmost care. Therefore, we recommend making use of market studies carried out by industry experts, which allow the market and its outlook to be evaluated. There are various market studies, which are usually carried out annually.
The multi-forces approach can also be used for this asset class.
Commodities and Precious and
The level and development of certain commodities will influence investor decisions about other asset classes and some sectors. High crude oil prices will benefit oil companies but will set companies that are strongly dependent on energy, such as airlines, at a disadvantage. Regarding energy in general, the levels of supply and demand influence prices, but these also depend on other factors as we mentioned earlier.
For agricultural products, supply and demand are the predominant influences on prices. Structural conditions in terms of production, the climate, and natural disasters will have an impact on the price of these commodities. Speculation can also be very strong, and the psychological impact of excessive media coverage can have consequences on the attractiveness of this category.
However, from a social and ethical point of view, we recommend that investors avoid this category and concentrate instead on the energy and precious or industrial metals industries.
Finally, in our analysis, we will concentrate essentially on industrial metals, apart from a few remarks about gold. Demand for industrial metals is strongly linked to the growth of the industry, which uses them in the production process. The growth of developed and emerging countries helps maintain the price level.
As for the other asset classes, the multi-forces approach can be used to better distinguish the various factors acting on prices.
The Four Forces of the Investment Model
The Macroeconomic Force
The Macroeconomic Force and Money Market Investments
The return from money market investments depends primarily on the movement of short-term interest rates. These are given by the money market and influenced by the Central Bank's policy in terms of inflation and growth. Upward pressure on interest rates results from a context of uncontrolled inflation and excessive growth. Conversely, controlled inflation or the beginning of a recession pushes rates down or keeps them stable.
Therefore, investors must follow the indicators for the country's inflation and growth in order to identify the potential for interest rate hikes or cuts. Furthermore, the meeting schedule of central banks (which are the dates for decisions about interest rate levels) should guide investors, particularly in their choice of maturity.
Interest rate levels essentially depend on the country's economic situation and on central bank policies.
The level of exports and imports, and therefore the balance of trade, are also factors that may affect interest rates. A central bank can take steps to avoid excessive appreciation of its currency against foreign currencies, either by intervening directly on the foreign exchange market or by changing its short-term interest rate policy.
Finally, a country's current account balance can also influence interest rates.
A deficit can push interest rates up.
In terms of the form of investment, a short-term fiduciary investment is most appropriate when interest rates are rising, as it allows investors to take advantage of any new rise. On the other hand, when rates are falling, money market funds are more suitable as they are less sensitive to further short-term interest rate cuts, precisely because they are invested in instruments with longer maturities. In the end, the choice between these two forms of investment will also depend on the investors' tax regime.
The Macroeconomic Force and Bonds
As we pointed out earlier, key factors to be determined are the potential increase or decrease of medium- and long-term interest rates, and expectations for inflation and growth. The 10-year rate is often used as a benchmark in practice. High or uncontrolled inflation is likely to result in a future interest rate hike and, consequently, a drop in bond prices. Conversely, low or controlled inflation prompted by economic slowdown usually leads to a future drop in interest rates and therefore an increase in bond prices.
In addition, it is important to determine the way in which short-term and medium- to long-term interest rates will develop. A parallel movement of yield curves1 is more dangerous for bonds, as they are all affected, whereas movement of a part of the curve only affects those that are located at the point experiencing the movement.
So, depending on the outlook, investors need to position themselves correctly on the curve and choose a specific duration accordingly.
To do this, investors must first examine:
the structure of the yield curve, to evaluate the potential for rising or falling interest rates;
inflation (controlled or not);
current short-term and long-term interest rates (high, low); the outlook for short-term and long-term interest rates.
It can also be useful to track the development of the budget deficit and the measures used to cover it. As we saw earlier, to finance its expenditure, the State can either increase its taxes, raise capital on the markets by issuing bonds or obtain funds from the central bank.
The deficit shrinks in periods of economic growth and grows during recessions or economic slowdowns. A budget deficit can stimulate growth and employment in an economy in recession, but an increase in public debt can have negative long-term consequences, both on stocks (low growth) and bonds (risk of inflation and interest rate hikes). We suggest the reader refer to our above comments on money market investments, which also apply to bonds.
The Macroeconomic Force and Stocks
This analysis should be performed by studying a certain number of macroeconomic indicators and must take into account their calendar and the calendar of earnings announcements.
Moreover, we recommend examining the level of market activity by comparing current volatility with its historical average (index VIX), as well as the trading volume. Strong volatility involves violent upswings or downturns. Such an environment is particularly risky, and wise investors should avoid this type of market.
Although this pertains more to the field of market psychology, a study of the put/call ratio can also help determine market sentiment. Growth is the major driving force that pushes stock prices up. Conversely, an economy in recession drives stock prices down.
Inflation and short-term interest rates have an influence on stocks. Falling or controlled inflation is a positive factor for stocks. Uncontrolled or rising inflation, on the other hand, is likely to lead to interest rate hikes, which is negative for stocks. As we saw earlier, it is essential to identify the type of inflation in order to correctly evaluate the implications.
A stock investment mainly signifies the purchase of future growth, and consequently, it is important to follow the indicators for growth and recession (particularly unemployment) to identify potential increases or decreases in growth rate. Investors must bear in mind that the stock market cycle anticipates the economic cycle and that the GDP report, which is published quarterly, only covers the past quarter.
Along with growth, interest rates are one of the most significant factors affecting stocks. To begin with, interest rates influence company valuations using a discounted cash flow (a higher discount rate implies a lower present value).
Furthermore, higher interest rates have a negative impact on corporate investments and the cost of borrowing, curbing companies' development. So an increase in interest rates has a negative effect, and vice versa for a decrease. Finally, the strength or weakness of the domestic currency can have an effect on stocks. A strong currency favors importing countries and companies, whereas a weak currency favors exporting countries and companies.
A study of the balance of trade and of the current account balance may also prove useful.
The Macroeconomic Force and Real Estate
Interest rate levels can influence price developments. An environment of low-interest rates favors real estate transactions and can, therefore, keep prices high. Conversely, high-interest rates can reduce returns because of the high cost of mortgages and tend therefore to push or keep prices down.
Moreover, when valuing real estate with discounted cash flow, low-interest rates increase the value of the property and high-interest rates tend to decrease it. Similarly to stocks, a rise in medium- to long-term interest rates is therefore negative for this asset class. Economic growth or recession have a considerable impact on the price of real estate. Indeed, the levels of housing sales or construction are important indicators for assessing a country's growth.
The Macroeconomic Force and Commodities, Precious and Industrial Metals
The overall economic situation (growth or recession) will have a direct impact on the demand for crude oil and industrial metals. A recessionary context will lower demand and, consequently, prices. The reverse is true for strong economic expansion. For crude oil, stock levels, especially American, will also play a role in setting prices. High stock levels will not encourage demand, while falling stocks will tend to increase demand and, hence, prices.
Geopolitical factors also add a risk premium which pushes prices up. This is especially true for oil.
Next, central bank interventions can have an impact on prices. When central banks are building up their gold reserves, prices are often pushed up, but when they are selling their reserves, prices fall. The strength or weakness of the currency and, more precisely, of the US dollar, can also affect the price of commodities, which are nearly always listed in US dollars. A weak dollar can help hold prices up and a strong dollar tends to have the opposite effect.
We saw earlier that the price movements of commodity futures depend on changes in interest rates, on storage costs and finally on the so-called “convenience yield”. Interest rate levels also influence prices. High-interest rates help increase the price of futures while low rates, on the other hand, will decrease their price.
Storage costs can indeed vary over time, but the magnitude of this variation is not usually very large. In general, an increase in storage costs is reflected by an increase in the futures price. As for the convenience yield, this depends on inventory levels and seasonal fluctuations. Thus, depending on the context, holding the commodity can confer advantages that the futures holder doesn't have. We gave the example of heating oil in winter.
The spot holder had an immediate advantage over the holder of the futures contract, implying, in this case, a high convenience yield and therefore a lower futures price (situation of backwardation). In other situations, this convenience yield will be lower, with the futures price higher than the spot price (situation of contango).
The Fundamental Force and Money Market Investments
As we started to begin with, the money market rate also depends on the counterparty (quality of the borrower) and, consequently, any change in rating will have an impact on rates.
A drop in the issuer's rating, whether for a fiduciary deposit or a money market fund, will increase returns but with a corresponding increase in counterparty risk. Conversely, an increased rating will result in a decrease in the rate offered while at the same time reducing the risk of the investment.
The Fundamental Force and Bonds
From a fundamental point of view, the credit quality (rating) of the issue and its development will influence the bond's price. A drop in rating will result in a lower price (with an increase in the band's return, as it becomes riskier) and an improved rating will increase the price (while pushing down the bond's return as it becomes less risky).
The type of issuer and its ability to satisfy its commitments will also determine the attractiveness of an issue. An increased level of debt has a negative effect on prices, while an improvement in the level of debt helps keep prices up. Therefore, it is important to examine the issuer's level of debt by analyzing, for example, the debt ratio or the interest coverage ratio. A study of the current ratio and the quick ratio can also be useful in determining the company's short-term liquidity.
The fundamentals of a particular industry or country can also influence price levels. When issues from a particular industry are more sought after, prices can be pushed up, particularly when the healthcare industry or the outlook of this sector is better than others. Conversely, neglected industries can see their issues lose value, due to the lack of investor interest.
The Fundamental Force and Stocks
a) Sector Analysis
We suggest that investors undertake a detailed strategic analysis of the various sectors of the economy, like the one we presented in Part III. This will help determine the sector's prospects according to the impact of macroeconomic events, the legal, political and tax environment and especially the barriers to entry which denote the existence of one or several market niches.
The outlook for the sector to which a company belongs has a major impact on the company. Once this first level of analysis is complete, investors can move on to identifying the strongest and weakest companies within the sectors.
THREATS OPPORTUNITIES STRENGTHS WEAKNESSES
i) Consumption and Spending
First, the levels of private consumption and public spending, as well as investments, should be analyzed, according to the type of customer for each sector, namely (household) consumers, companies or the government.
The consumer confidence index, retail sales, and personal income are all indicators to follow, as they help determine the attractiveness of businesses that depend on private consumption. As we noted previously, the computer and leisure sectors depend on sales to consumers. A drop in these indicators can lead to a drop in sales for the companies operating in these sectors.
The development of the State budget and planned expenditure is key to determining the attractiveness of sectors that depend on the government, such as defense, aerospace or infrastructure. An increase in planned spending will boost them, whereas budget cuts will hold these companies back.
Finally, indicators such as new orders and industrial production and capacity utilization rate will indicate the level of investment in sectors dependent on the consumption of companies, such as manufacturing or chemicals. Rising indicators will have a positive effect on these companies while deteriorating indicators will do the opposite.
ii) Production Process
Depending on the production process used (workers, machinery, oil, mixed), macroeconomic factors will have different impacts.
The rise and fall of interest rates have a greater impact on capital-intensive companies such as utilities, as it can affect the cost of borrowing capital. Labor-intensive companies, such as those in the retail sales sector, are more exposed to rising and falling unemployment rates and wage inflation. Fuel-intensive companies, including those operating in the transport sector, are greatly affected by oil price fluctuations.
iii) Growth and Cycles
Whether or not the economy is growing or in a recession will also influence which industries to buy and which to avoid. In a growth phase, cyclical sectors, such as the automotive industry, construction or transport, should be favored as they react more strongly. However, they should be avoided in periods of economic slowdown or recession, where the so-called non-cyclical sectors are preferable, such as healthcare, pharmaceuticals or food.
The strength or weakness of the domestic currency can have an impact on a given industry. A strong currency benefits import-oriented sectors, while a weak currency favors export-oriented sectors, like agriculture, industrial equipment, computers or pharmaceuticals. Export-dependent sectors react more strongly to the balance of trade and currency fluctuations.
v) Energy, Metals and Commodity Prices
The price of energy (crude oil, gas) also has an influence. An increase in oil prices benefits oil companies but has a negative effect on airlines and road transport companies.
A rise in the price of metals will benefit mining and producing companies but will penalize companies that use the metals, such as construction companies. Similarly, an increase in commodity and staple food prices which can be reflected in their retail prices will favor producing companies, but the impact can be limited by a strong currency. On the other hand, the impact will be negative for companies that buy these commodities, and for those that produce them but cannot easily reflect the price rise in retail prices.
The climate can also influence sales and therefore corporate margins. A favorable climate allowing abundant harvests helps push prices—and therefore producer margins—down, but will increase margins for buyers whose purchase costs are lowered. Conversely, small harvests due to poor weather conditions will push prices up, which will benefit producers but not buyers.
b) Analysis of Individual Stocks
The second step is to complete a detailed analysis of the company, in light of several different criteria.
It can also be worthwhile to classify stocks in one of the six categories outlined by Lynch to determine not only the attractiveness but also the holding period of the investment. In blog 5, we mentioned the following categories:
1. Slow growers;
2. The stalwarts;
3. The fast growers;
6. The asset plays.
i) Business Model and Competitive Advantage
As we noted earlier, it is essential to understand how the company makes money, i.e., to be familiar with its business model, which should be easily understandable. As an investor, it is advisable to have at least some knowledge of a particular sector before investing in it.
Company websites are a good place to start, as they provide a good description of the business's activities, and financial statements give a more precise idea of how these activities are distributed. It is also important to determine the company's competitive advantage(s), as this is what defines its positioning in the relevant market and allows it to develop. As such, the following points should be examined:
the company's market share;
its revenue, including distribution of sales;
its growth rate;
the growth of the sector;
We favor solid, enduring businesses (large companies), whose product or service is durable, i.e., is unlikely to become obsolete. Regular sales are necessary, so the product's sales percentage (impact of the product on the company's sales) should be examined. Finally, it is easier for a company to develop and win market share in a low growth sector.
The management team is what drives the company, and this role must be occupied by top class individuals. A company run by its founder is obviously ideal (Bill Gates, Michael Dell or Warren Buffett, for example), but if stocks are held by the company's managers and executives, this is also a positive sign.
So, the quality aspect should be taken into account. For example, the arrival of a new manager with a lot of experience in the sector should be regarded as positive for the company. The company's website will provide information about the management team and their experience (CV, careers). CEOs sometimes appear on television and regularly grant interviews with major newspapers or specialized magazines.
Corporate governance rules, which define the relationships and responsibilities between management and shareholders, help gauge the degree of independence in decision-making and the degree of protection of shareholder interests. The fact that the Nobel Prize in Economics in 2009 was awarded to Elinor Ostrom and Oliver Williamson for their work on economic governance and the organization of cooperation demonstrates the importance for the economy of these rules.
iii) Financial Health
First, the company's short-term liquidity ratio must be examined, essentially by studying the current ratio and the quick ratio. Then the company's long-term debt should be studied, by examining the debt ratio and the interest coverage ratio.
The company must have adequate liquidity. It can also be useful to calculate the net cash value per share, then subtract this from the market price, and finally divide it by earnings per share. These ratios are available on financial information websites or calculated using the balance sheet, which indicates what the company owns (assets) and owes (debts).
As we noted earlier, it is especially important to examine the development of these ratios over a three–five-year period. This first step will help determine the company's default or bankruptcy risk.
In this regard, the ratings attributed to companies by credit rating agencies can influence their stock prices, as these ratings represent their financial soundness. A drop in rating often leads to a fall in stock price, not to mention the impact of the higher interest rate the company will have to pay on the market to raise capital.
iv) Earnings per Share, P/E and P/B Ratios
A stock's return consists primarily of a share in the company's earnings. The company should ideally have a continuous record of dividend payments, i.e., stable and, if possible, increasing dividends. It is therefore important to examine the earnings per share by studying the income statement. This document indicates what the company generates and spends, with the difference representing a profit.
An increase in earnings over time, thanks, for example, to improved sales, has a positive effect on the stock price. Spending should ideally remain constant, or at least increase at a fairly low rate—lower than the rate of earnings growth. Companies with high margins are obviously preferable, particularly because they have a larger safety margin for coping with a difficult environment.
It is useful to track the development of earnings per share (EPS) over time and to study the estimates made for the company. Using the EPS, we can calculate the Price to Earnings Ratio (P/E), examine its historical development and analyze the estimates for the future. Obviously, this should be compared to the P/E ratio of the industry in question, as the P/E is a relative measure. Very high P/E ratios are usually to be avoided.
As we mentioned previously, it is also useful to examine other ratios, such as the Price to Book (P/B ratio), ideally situated between 1 and 2, or the Price to Cash Flow ratio. Finally, it is worth comparing the stock price movement to earnings growth and the P/E ratio graphically.
v) Earnings and Future Prospects
When buying a stock, investors are buying future growth, so it is essential to determine the company's ability to increase their earnings in the future.
The announcement of good results generally has a positive impact on the stock price, especially when the company has exceeded expectations, or publishes good figures in a difficult economic environment. Obviously, the same is true for forecasts for future results, even if they are only estimates. This estimate will help determine an intrinsic value, which can be compared to the stock price.
A programme of cost reduction or the sale of certain company divisions—for reasons of profitability, price or a willingness to focus on its core business—will also have a positive impact on the stock.
Stock repurchases, undertaken by the company itself or by its management, will have a positive effect on the stock. The same is true of a tender offer on the company. It can also be useful to examine the results published by competing companies, to get a better idea of the sector's growth prospects and those of the company in question, as in principle they operate in the same environment.
vi) Free Cash Flow
The company's ability to generate cash is probably the most important criterion for investors. A high free cash flow enables the company to repay its debts, pay dividends, undertake stock repurchases and especially to ensure its future growth.
A company has three sources available for generating cash, namely operating activities, investing activities and financing activities. All these factors appear on the cash flow statement.
It is also useful to study the development of inventories. A growing inventory can be a negative sign for the company, which eventually will have to lower prices to liquidate stocks or wait longer to sell them. Conversely, diminishing inventories are a positive sign for the company.
viii) Specific Risks
Finally, it is a good idea to study the political risk of any new regulations applying to the business, of nationalization or even boycotts driven by consumers. The media (newspapers, official reports, political debates, etc.) usually provide this type of information.
The Fundamental Force and Real Estate
The fundamentals of the real estate market in question will mainly depend on supply and demand, and on demographic development. The demography of the region will strongly influence prices. An increasing number of inhabitants or individuals requiring housing will push up the price of existing real estate. Furthermore, the size of the territory and the area authorized for construction will also influence prices.
Excessive construction and mortgage levels should be studied closely, as these factors can lead to a real estate bubble which, when it bursts, will see prices collapse. The collapse of the Dubai real estate bubble, which had indeed been fed by excessive construction and borrowing, is a perfect example.
A specialized real estate study will allow these fundamental factors to be evaluated.
The Fundamental Force and Commodities, Precious and Industrial Metals
Population growth and the appearance of a middle class in emerging countries, whose needs will increase over time, have an influence on prices.
A country's or industry's limited reserves or the scarcity of an energy resource or particular metal will also contribute to price rises. The development of renewable energy or alternative materials may limit this impact, but the cost of research and development must be taken into account.
To a more limited extent, the climate and natural disasters can have an impact on prices, but these affect supply and production capacity, which must be placed in the context of overall demand. Interruptions in production due to natural disasters will probably have a limited impact on prices in a context of weak demand.
Finally, State interventions, particularly in terms of new or increased taxes, can have an impact on prices.
The Technical Force
The Technical Force and Money Market Investments
Interest rates usually follow a cycle that alternates a series of increases towards a peak, then a series of declines, leading to a trough.
Using a chart to study interest rate movements helps determine the current point in the cycle. The main objective is to identify the turning point. An initial rate hike increases the prospect of future hikes and an initial cut suggests more cuts to come. Investors should use these pivotal moments to position themselves correctly and to choose the appropriate maturities.
In the event of an initial increase in interest rates, it's important not to choose too long a maturity, so as to avoid getting stuck while rates continue to rise. Conversely, after an initial drop in interest rates, long maturities can be considered, this time to lock in attractive terms for a long period in the expectation of lower interest rates in the future. A comparison with the returns offered by bonds is essential in order to choose the more appropriate instrument.
The search for specific technical patterns is of little use in the case of money market investments. Expectations for inflation and growth are thoroughly decisive (macroeconomic force), as it is these expectations that will influence central bank policy and therefore short-term interest rates.
The Technical Force and Bonds
Regarding bonds, it is important to distinguish between an investment held to maturity from a short-term investment. In the first case, technical analysis is somewhat superfluous as investors seek simply to block a return over a given period, to earn coupons and recover the invested capital at the moment of final redemption. Interest rates and their expected development are the decisive factors here.
In the case of more speculative investments, forecasts of upcoming price increases or decreases can be used to make a profit, so a chart analysis of the interest rate cycle and bond price movements may prove useful. However, for bonds, the macroeconomic and fundamental forces, and even the behavioral force will have a more significant impact than chart patterns.
The Technical Force and Stocks
A detailed chart analysis is necessary because some investors base their investment decisions mainly on the technical aspect. It's worth being on the same side as the technical analysts.
It is important to look for specific patterns and support and resistance levels. Indeed, some investors buy or sell on the basis of a technical pattern in the observed price, or an ostensibly relevant level being broken through. In our opinion, Fibonacci retracements can also provide very useful indications. Most important is to determine the trend, whether it is bullish (higher highs and higher lows), bearish (lower highs and lower lows) or sideways.
The Technical Force and Real Estate
Interest rates usually follow a cycle that alternates a series of increases with a series of declines. A chart analysis of historical movements helps investors situate the current point in the cycle and thereby determine the prospects for interest rate hikes or cuts, which will have an impact on real estate. Medium- to long-term interest rates, or the three, five and 10-year rates are those to consider in this case.
The Technical Force and Commodities, Precious and Industrial Metals
A chart analysis of prices and patterns can help determine the direction in which prices are moving in this category, which is generally subject to speculation. Note, however, that the development of prices for industrial metals is strongly linked to the economic cycle.
The Behavioural Force
The Behavioural Force and Money Market Investments
This force is of limited importance for money market investments.
However, for fiduciary investments, a particular counterparty's attractiveness to investors can justify a lower interest rate being offered. If investors want to lend their money to a particular borrower because of its credit quality in a context of strong uncertainty, the borrower can afford to offer lower rates due to the strong demand.
Conversely, a borrower which is subjectively regarded as riskier, even if its rating remains unchanged, may be forced to offer higher interest rates by this psychological force sustained by investors.
The Behavioural Force and Bonds
At the psychological level, major insecurity or a risk aversion to stocks or other asset classes can strengthen the attractiveness of bonds and push up prices, sometimes higher than they should be. Thus, such an “exaggeration” can originate in an irrational behavioral force, not based on return criteria, for example, but simply on the desire for the additional security offered by bonds.
The recent financial crisis drove many investors to buy bonds in 2008; this asset class alone was favored and the stock market was neglected. Some investors, affected by this force, threw themselves on lower-quality bond issues that they would not have considered under normal market conditions.
The Behavioural Force and Stocks
First to be considered is the optimism or pessimism of investors or market players. Confidence indices provide an initial impression by indicating the economic climate in which economic agents are operating (consumers, business managers).
A study of the media, particularly newspaper headlines, articles and especially the vocabulary used, helps to pinpoint this sentiment and any risk of a speculative bubble forming. We are referring here to the strength of association that we talked about earlier. Noise and excitement generated around an industry or stock can also provide precious indications. It is better to avoid investing in companies whose popularity is solely due to a fad.
Moreover, in a context of asymmetrical information, investors tend to believe that others are better informed, which causes mimicry (the “herd” effect).
Investors also tend to underreact to news due to a conservative bias that leads them to under-weight recent information compared to prior information. Furthermore, the self-attribution bias leads them to overweight information that confirms their first evaluation and underweight information that is inconsistent with it.
As such, it is worth reiterating that in pre-crash periods, individuals tend to underreact to extremely negative news and overreact to extremely positive news. These under- and overreactions subside after the crash, but remain present nonetheless.
It is obviously very difficult to determine this force and its direction, if only because of a large number of individuals interacting in the market. However, exploiting these lags in price adjustment to information can help investors to position themselves properly in the market. We have also seen that individuals underestimate the frequency of repetitions and see cycles as mean reverting. Therefore, these “psychological” turning points should be taken into account.
Fads (trends) or rumors should also be taken into consideration as they can occasionally push investors to buy stocks or favor a particular sector, as was the case with Internet companies in the lead-up to the speculative bubble of the 2000s. Finally, the attractiveness of other asset classes can determine the attractiveness of stocks and push prices up or down.
The Behavioural Force and Real Estate
Real estate speculation obviously contributes to price rises. So the establishment of a real estate bubble must be monitored very closely because of its possible collapse and the consequent impact on prices. Unfortunately, the subprime crisis is not yet a distant memory, any more than the Dubai crisis.
The desire to become a homeowner or landlord, linked to a country's culture or to tax incentives, can also help push property prices up. Finally, a preference for more regular income and capital that fluctuates less over time can also lead investors to favor this asset class and therefore contributes to price rises.
The Behavioural Force and Commodities, Precious and Industrial Metals
Media coverage, the proliferation of articles and features on commodities and metals can have a psychological impact that strengthens the attractiveness of this asset class.
1 Graphical representation of interest rates by maturity.
2 Future price = Spot price * (1 + risk-free rate) + storage costs − convenience yield.
3 Current assets minus long-term debt, divided by the number of shares outstanding.
Finally, we propose to summarise what we believe are the most relevant factors for each force, in regard to each of the asset classes we have selected.
All throughout our analysis, we have tried to identify the elements that can influence prices in the financial markets.
What we are providing here, above all, is an investment framework based on these four forces, and we leave it to each investor to determine the factors that he or she considers the most appropriate for judging the attractiveness of an asset class, and to make decisions accordingly.
A Final Example: Analysis of the Subprime Crisis
We would like to conclude our analysis with one last example: the recent subprime crisis and the financial crisis that followed. Using this example, we can briefly illustrate the attractiveness of an asset class in light of the proposed investment model.
We have decided to focus on stocks and to analyze the most relevant factors. With the United States as a point of reference, let us now reconstitute an analysis of early 2008.
a) The Macroeconomic Force
By examining the volatility index (VIX index), we could see that over the previous months, the level of market activity had exceeded the historical average, which is generally situated around 15–16% (average volatility of the S&P500). In January 2008, it was positioned at about 24%.
Furthermore, short-term interest rates had been falling since August 2007, and the Fed had decided on 22 January 2008 to lower the official market rate to 3.50%—a drop of nearly 2% in less than six months.
It was also interesting to analyze the development of and the difference between the short-term and long-term rates, taking the three-month LIBOR and the 10-year US Treasury yield as benchmarks. Besides the short-term interest rate cuts, we could see in particular a fall in the 10-year yield, indicating a rise in bond prices, the beginning of expectations for a crisis and of weaker inflation to come.
Looking at the report published on 21 February 2008 by the Conference Board, the US leading index had fallen for the fourth consecutive month in January. According to the OECD report of 11 January 2008, the composite leading indicators were signaling a slowdown in growth prospects for the biggest OECD member economies, with a downturn in the US.
In terms of growth, we also noted the drop in the Gross Domestic Product (GDP) in early 2008. Finally, examining the development of the ISM Manufacturing Index, we noticed a contraction of industrial activity, with the index falling below the threshold of 50. The Baltic Dry Index indicated a major slowdown in worldwide commercial activity.
Therefore, in January 2008, all these factors pointed towards a Macroeconomic Force that would push stock prices down. Some indicators were beginning to deteriorate, showing that the bullish trend of 2003–2007 was reversing towards a new bearish cycle, whose magnitude was, at that stage, impossible to determine.
b) The Fundamental Force
We will not undertake a detailed strategic analysis of industries and individual stocks. However, with the subprime crisis having erupted in summer 2007, we believed that banks were the most exposed (specific risk of this sector that was, therefore, best avoided).
Nonetheless, it was worth studying several factors in order to determine the attractiveness of certain industries.
Looking at the price of crude oil, we found that this had jumped dramatically, reaching nearly 100 dollars a barrel. This favored oil companies but was beginning to disadvantage industries dependent on oil (airlines, transport). We know now that it continued to climb, reaching almost 150 dollars.
In terms of the EUR/USD exchange rate, we could see that the dollar had depreciated sharply, reaching the historic level of 1.50 to the euro. This favored American exporting companies, and European companies that could obtain supplies from the US at better prices.
The commodities index showed a strong appreciation, due particularly to the weakness of the dollar.
Examining the level and development of the P/E ratio (S&P500), we noticed that it had fallen sharply, reaching historically low levels, with more attractive stock prices. However, as we have mentioned, it is important to treat this ratio with caution, as it mainly depends on the company's earnings per share, which can fall.
We also noted that the P/B ratio (S&P500) had dropped, returning to more reasonable valuation levels (as a reminder, during the excess of the Internet years, P/B ratios had reached levels of 5). Fundamentals were more difficult to estimate and opposite forces could prevail depending on the sector in question. However, we considered the banking sector to be avoided, or at least highly risky.
Incorporating the macroeconomic indicators, we believed that a weak to moderate downwards pressure was acting on stocks.
c) The Technical Force
From a technical point of view, the S&P500 chart for the previous 10 years showed a magnificent example of the “double top”, where we could also see that the bullish trend begun in 2003 was starting to reverse, with the appearance of “lower highs” and “lower lows”. The resistance of around 1520 had been tested several times without breaking and could not be used as a new support level.
The Technical Force was, therefore, pushing down on stock prices, but only generally speaking, as we have taken the S&P500 index alone into account.
d) The Behavioural Force
During this period, other than the abundance of articles on subprime mortgages, we could sense the beginning of a climate of mistrust, fed strongly by the press which, in general, was using a negative vocabulary. The strength of association would gradually take effect.
Moreover, a certain pessimism had begun to take hold, as shown by the American consumer confidence index, which had worsened considerably in 2008. The University of Michigan index had dropped below 80 in late 2007, and in March 2008, it reached 69.5, the lowest since 1992.
The Behavioural Force had also begun to pull stocks down.
In the light of all these factors, it appeared in early 2008 that the resulting force was pulling stocks down rather than pushing them up.The extent to which equity was to be reduced in a given portfolio depended on the investors' degree of conviction about a (strong) correction in this asset class —the element the most difficult, if not impossible, to predict at that time. Market movements follow cycles and a bearish cycle alternates with a bullish cycle over time.
For money market investments, the drop in short-term interest rates suggested blocking fiduciary deposits into a long maturity to profit one last time from the high prevailing rates. Money market funds would then take over.
Considering the drop in long as well as short-term interest rates, bonds were to be favored and their maturity to be chosen according to expectations for inflation and future possibilities for rate hikes. At this time, durations of three to five years were usually advised. Given the weakness of the dollar, commodities, especially energy, remained attractive. Real estate, in the context of the subprime mortgage crisis, was obviously an asset class to be avoided or at least seen as extremely risky.
Scaling Portfolio Management to an Enterprise
One of the questions I heard between the first edition and this edition was, “How do I scale what I do with my team or a couple of teams to the entire organization?” If you have a large organization you might also have this question, and this blog gives you the answer.
In this blog, you’ll see how you scale from both directions: bottom up and top down. Do not try to “scale” the project portfolio using either one mode or the other. You need the details to discriminate among each project at the group or business unit level. You need the mission or strategy at the enterprise level to make large decisions.
Understand How You Work Together Now
In very large organizations, you might realize you work in functional silos. I know of a large organization of more than a thousand product developers organized as shown in the figure.
Note that the teams are silo teams. In fact, the directors managed pools of people as resources. They never thought twice about moving people from one project to another or having people work on several projects at one time.
When they wanted to manage their project portfolio, they had several decisions:
What projects did they want people to work on?
Which teams did people work on? They had to assign people to work on just one cross-functional team.
If you are transitioning from a waterfall approach to a more agile approach for your projects, you might also have an organization that looks like this.
This organization had a huge problem: each director had MBOs (management by objectives) that put that director in competition with the other directors. If they had tried to collaborate to create a project portfolio, some of them would not have received their bonus.
In reality, they had several projects and programs. They decided to organize the programs first because they accounted for much of the work. They explained the notion of programs and projects to the CIO. They also asked to change their compensation structure so they could start to collaborate.
The CIO was a fan of incremental work. He was new to agile, so he was a little suspicious. On the other hand, he understood the compensation structure was in the way of managing the project portfolio. He agreed. The directors created cross-functional teams, assigning the teams to projects and programs. They didn’t change where people sat or the reporting structure.
When you have silos and you reinforce those silos with compensation, decide how to start the change to having people work by project. If you have an organization based on function, decide how to manage that problem before you start scaling any project portfolio work.
Does Your Organization Suffer from Resource Efficiency Think?
Some managers think of people as “resources.” One consequence of that thinking is that managers think they or the teams can split work to make people more efficient. We split this work by work type, creating experts. The name for this is “resource efficiency.”
You can see evidence of resource efficiency thinking in these conditions:
Managers want to see 100 percent utilization for each person, optimizing for the person, not the team.
People have narrow expertise. Work queues behind those people for multiple projects.
Managers refer to people as resources.
High utilization makes no sense for knowledge work. People need time to think and to innovate.
When we flow work through teams, we see the highest throughput. It doesn’t matter if we talk about features or projects. Flow efficiency allows us to finish work faster and therefore increase our capacity for more work. Use a view that helps your organization realize it’s the finished work that counts, not the started work.
If your organization has trouble managing the project portfolio, rethink how you consider teams and people. I like to show management which people are working on what projects—and which projects they are not working on. That helps everyone see the flow of work through your organization. When you add WIP limits, everyone can see that pieces of people—especially alone—do not help a project finish fast enough.
What if You Need a Little Bit of a Person?
I’ve worked with many teams that thought they needed a part-time person: DBA, UX, or tech writer.
It’s possible you only need that person once for ten hours one week. It’s unlikely. What I’ve seen is you need this person for a couple of days now and a couple of days next week. Then you need that person more in a week or two. That’s when you discover the person needs to change something. Or maybe the team found a problem with the original contribution. Your project needs that person more and more.
The person is a part-time contributor on two or three projects. Murphy’s law (and other arrival curves) explain this person is now a bottleneck on several projects. This is a great example of resource efficiency thinking creating a substantial Cost of Delay.
Instead of thinking about bits of people—resource efficiency thinking—think about how that person can help a team over time, not once in a while. Can you ask the team to work together to share this person’s expertise? The team might not become expert in what the expert can do. On the other hand, maybe they can maximize the expert’s time with the team.
When you work in flow efficiency, you reduce the Cost of Delay due to experts and multitasking—any wait states. When you work in resource efficiency, you maximize the Cost of Delay because you’re always waiting for something. That decreases your organization’s overall throughput and capacity.
Flow Similar Work Through Teams
I’ve seen management change project assignment for teams. Their rationale is that they want the teams to learn other parts of the product. I like this idea of team learning. Know that it takes time for a team to learn. You can flow work—including different work—through teams. Each team will have a different amount of time to learn that area. And it’s likely that the team will forget what they learned the next time they work on this area.
This “change what teams work on” is another form of resource efficiency thinking. You will incur a Cost of Delay due to team learning time. What if you really want to get the next-ranked project done and the “right” team isn’t available? Go ahead and use the available team. Recognize that team might need training or time to learn. You will not see the predicted project completion time because the team needs time to learn.
Create a Holistic Perspective of All the Work
When each group has a project portfolio, you can see them. And the portfolios might not be coherent across the organization, especially when everyone has made their own decisions.
At this point, leave the decisions alone. Your first role is to make the information transparent.
Show the Work Now
I recommend you gather each product line or business unit’s representatives in a large room with enough wall space to show everyone what’s going on. Ask each business unit to provide a large poster of their quarter’s plan. The poster should be about four feet by six feet, so everyone can see one quarter’s work in large-enough lettering.
I ask people to post their boards. I ask one person from each business unit to stand by their board, and everyone else to walk around. As people walk around, I encourage these questions:
What principle(s) is(are) behind your decisions?
How did you determine value?
Are any of these projects really programs?
If your organization has other questions, ask them. I tend to stick to data-gathering at this point. I want to know how people made their decisions. I don’t want to pass judgment on those decisions.
Define Each Group’s Decision-Making Criteria
Ask each group to explain their principle behind their project portfolio of active projects. Back in Articulate Your Mission to Prepare for Collaboration, I said each person needed their mission, the principle for decision making, and their strawman portfolio. It’s the same thing at the enterprise level. What is each group’s mission, principle, and portfolio?
Although I counsel organizations to have a unifying mission, that mission might be too vague when you work across business units. Imagine you have a 20,000-person organization. In that organization, you are part of a business unit with twenty or more various products. Your mission, “Bring robotic vision to the mass market,” might not be sufficient for decision making.
On the other hand, you might have a mission, “We bring a unified approach to robotic vision to the mass market.” Once you say, “unified approach,” you are saying, “We will work together across this business unit.” You might discover that you have not defined your business unit’s mission or strategy enough to use it for decision making. Consider your strategy.
Define Strategy at Your Level
You can think about strategy in any number of ways. I don’t happen to like SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis. To me, it’s too inward-looking. If it works for you, great. The strategy is how you define and achieve your future organization. You need both great execution (how you manage the project portfolio can help) and understanding of what the future is (understanding your corporate values and how you want to compete in the future).
I prefer an iterative approach to define and live your strategy. I like thinking about strategy in Top Management Strategy: What It Is and How to Make It Work.
Every organization has different operational and strategic strengths. The managers and teams need to understand
Why did the organization select this mix of projects? (The reasons behind the choices in the project portfolio)
What do we need to deliver to the customers? (The implementation of the strategy)
How do we deliver to the customers? (Our operational strengths)
Some organizations are great at the Why, What, and How. Many more have trouble somewhere in the strategy, product planning, and operational delivery. Especially if you want to scale the project portfolio, start with the Why: the reasons behind the choices in your project portfolio.
Define Your Driving Force, Your Why
If you want to achieve a visual project portfolio at the corporate level, define the driving force for each business unit. I’ve numbered this list in rank order of what people often select as the real driving force. You might decide that your technology is the driving force, rather than your products, especially if you are in a young market. Once you’ve determined how you present your technology in the form of products, your products might be the driving force. Your strategy changes over time, as your driving force changes.
Here are some possibilities for driving force:
1. What you offer for products and services: your products.
2. The markets you serve: Do you serve a specific market?
3. Your technology: You might have unique technology.
4. How you sell: Do you have a dedicated sales force who can target customers and sign them? Do you need a sales force?
5. How you distribute: Do you have limited or expansive distribution capabilities? In software, can you distribute as SaaS, or do you package your software in some way?
6. Natural resources: Do you consume or save natural resources in some way?
7. Production capability: How good are you at producing your product? For software, you might consider continuous deployment.
8. Size/growth: Fast-growing companies can be attractive to investors and customers.
9. Return/profit: This is a consequence of selecting reasonable driving forces. This does not change the nature of the business.
10. Membership: Are some people attracted to your products and services? Do you limit membership? If so, how is that working for you?
Why Can’t Return or Profit Be a Driving Force?
You might wonder why I say return or profit is a consequence of a driving force.
You achieve return or profit by the projects you implement and not doing the projects you ignore. If you select work based on anticipated return alone, you will never select the high-risk/high-return projects. You will never try any Advanced R&D work. You will reduce your risk and lose business.
You want a high return or profit for the work you do. I understand that. Define your driving force and allow return to be an oblique effect. You have one driving force for a given business unit. Each business unit has its own driving force. The overall organization might have a different driving force. If you have a large organization where part of the organization creates products and part is consulting, each part might have its own driving force: technology for the products part, and how you sell for the consulting part.
Have each business unit define its own strategy. Then, decide what the overall organization’s strategy is. You might decide—at some point—that the two business units need to be their own companies. You might not gain any benefit from the affiliation of the two business units because their driving forces are different. The organization cannot meet the needs of each business unit in its current configuration.
If you discover you have many business units, each with its own driving force, define your corporate mission and your corporate strategy. Otherwise, you will have trouble deciding on an overall project portfolio.
You might think you have multiple forces if you have not managed your project portfolio before. You might have a spectrum of products that create a new way of doing things or projects that exploit your technology. Maybe you are geographically distributed to be near your customers, an example of using markets as a driving force.
You have one driving force. When people across the organization believe they have multiple forces, they have trouble deciding which project to rank first, second, third, and never. Unify the organization, so you can create a project portfolio that works.
Your driving force differentiates you from your competitors. Use that differentiation as the basis for your strategy. Here’s an example. Imagine you are a machine vision company. You have software that allows a regular camera to take panoramic images. Your driving force is your technology.
One day, you realize you have a competitor who does the same thing as you— except it’s not quite as good as your software. You move from technology to your products and services as the driving force. Maybe you decide to create additional support services, or a cloud-based service with automatic panoramas, or something else. That’s how your driving force will suggest alternative work for you. For organizations where technology is the driving force, I like to assess the strategy every quarter and update the project portfolio every month or two.
Define the What for Each Product
Once you know your strategy, it’s time for product management to define what goes into each project to implement the strategy. That often means the product management people have this work to perform:
Define a roadmap of what the product will be over its life cycle:
beginning, middle, end of life.
Define a roadmap for the next few quarters (or months) to show what interim releases will deliver.
Define a given project’s backlog: what this next milestone will deliver.
Note that roadmaps are not requirements documents. They are a high-level picture of what you want to achieve when.
In Agile and Lean Program Management: Scaling Collaboration Across the Organization I recommend you have at least these two roadmaps: the big picture for several quarters out and not more than one quarter at a time The big picture roadmap shows you where you want to be after several quarters. Here, I’ve shown six quarters.
The small picture roadmap shows where you want to be after one quarter. I’ve shown monthly internal releases. If your organization can release more often than once a month, that’s great. I recommend for the purposes of the project portfolio you release at leastmonthly. Roadmaps are a wish list. They are a planning mechanism. There is no guarantee the teams can produce what is on the roadmap in the time you want them to. On the other hand, if the teams don’t know what you want, they cannot deliver it.
Define How You Will Deliver a Great Product
The goal of project portfolio management is to calm the organization so you can increase your throughput. As I said your customers don’t care about your project portfolio. They care about what you deliver to them:
Is what you delivered what they need?
Does what you delivered work?
Does what you delivered solve their problems?
In addition, you want to know if the projects in your project portfolio create a healthy business. You can assess that by seeing if the projects meet your driving force as described in Define Your Driving Force, Your Why. Your ability to deliver is key to being able to manage your project portfolio.
Your delivery is related to the life cycle a given project selects. You can use any life cycle for your projects. Depending on your risks, some are better than others. For the purposes of managing your project portfolio, an incremental or an agile approach will provide you more frequent opportunities to assess and replan your project portfolio.
If you are delivering well now, what about your project approaches work well for you? Continue as you are.
However, if you are not delivering well now, or not as well as you would like, what do you need to do to deliver finished features more often? The more often you deliver finished features, the more often you can obtain feedback about what your customers need, whether what you delivered works, and if what you delivered solves your customers’ problems.
Ask These Questions for Each Business Unit
You have the work as in Show the Work Now. You understand the principles by which each business unit made its decisions. You know the corporate strategy and your driving force. Now it’s time to ask these questions:
Will this work help us implement our strategy?
Will this work distract us from our strategy?
Your project portfolio implements your strategy. If you don’t know your strategy, your portfolio will be random, not coherent. If you do know your strategy, you can make better decisions. If you want to change your strategy, decide which projects to fund now and later.
Beware of the Sunk Cost Fallacy
In high tech, we change our driving force over time. We often call this a “pivot.”
I sometimes hear people say, “We’ve invested so much in this effort. Can’t we just finish it?” Back in Don’t Recommit Because of Sunk Cost, I warned you about recommitting because of sunk cost. It’s the same idea here.
If you are pivoting or changing your driving force, do not consider sunk cost. You’ve spent that money. You may never do anything like that again. Conduct a retrospective (what made us think this was a good idea?), have a celebration and say goodbye to that work. Look forward, not backward.
Start with Strategy and Paper
One of the problems I encounter in large organizations is that they want to see all the portfolios. They look for a tool first. Don’t start with a tool. Start with your strategy and paper on the wall. I have nothing against tools. However, all tools have one shortcoming: they don’t ask you if you understand the strategy, or if this work will help you implement the strategy or distract from it.
Once you have practiced reconciling your strategy with your current project portfolio, investigate tools and try one (or more). I find the discussions about strategy are more difficult than making decisions about the project portfolio.
Start Here with an Agenda for a Corporate Project Portfolio Meeting
I can’t provide you with the definitive agenda for a corporate project portfolio meeting. That’s because some of you are in the midst of market change or internal change. Those changes will require you to change how you work. I recommend you start here and adjust it for your needs.
Before the Meeting
Decide who you need to invite. This is a decision-making body. I’ve seen names such as “Operations Committee,” “Project Management Office,” and “Senior Management Team.” I don’t care what you call yourselves, as long as you can make decisions about the corporate strategy.
Explain to everyone what they need to bring to the meeting. Make sure every business unit provides paper versions of their current project portfolio. See Show the Work Now.
Do you have a need for everyone to provide the information in some way? You might need to see what is in Advanced R&D for each business unit. See Decide How to Manage Advanced Projects.
Ask everyone to provide their driving force and the mission for the business unit. Decide how much beauty you need in these displays. I ask people to use large stickies or cards on the wall. I specifically ask them not to spend much time making the cards beautiful. This is preparation work. I liken it to paper prototypes.
During the Meeting
1. Explain the state to everyone.
I ask people to walk around and spend up to ten minutes per business unit, reviewing the contents of each board. If you have many business units, you might want someone to brief the room, spending no more than five minutes explaining the board contents.
If you need more than five minutes to explain your board, consider the level of work you are explaining. Are you detailing all the fixes, each in its own detail? Or do you have a project labeled “Fixes,” or can you integrate fixes into “Project A and Fixes”?
Make sure each business unit clarifies its position: mission, principles, and current project portfolio.
2. See where you have disconnected.
Is one business unit spending more time and energy on something another business unit ignores? List all the disconnects. List all other concerns, such as “I will need that product in time for Q2, and you folks aren’t starting it until Q2.” Capture these disconnects and concerns on stickies.
3. Bucket the disconnects and concerns.
I have used these categories for disconnects and concerns:
Strategy differences. We disagree with the strategy, which is why we have a problem here.
Timing problems. Your results are too late for me. We need to address this and possibly transform these projects.
Other problems. You may find that you discover other challenges. When you group stickies together as an affinity group, you can see patterns. Those patterns might help you see possibilities. Affinity-group and name these groups. If you wrote the disconnects and concerns on stickies, you can affinity-group all the problems. I always create the buckets of strategy and timing. Some teams discover they have other problems such as obstacles.
4. Resolve the strategic differences first.
Strategic differences affect the entire organization. Resolve those first. You might need some of the facilitation or project portfolio questions in blog 6, Collaborate on the Portfolio. You are deciding on how to implement your strategy. You all need to collaborate to do so.
5. Solve the other problems next in order of importance.
I find that the buckets are not the same importance. I discovered that if we fix the most urgent challenges, we have fewer/none of the remaining challenges.
6. Decide on the view you want to provide the rest of the organization about the relative priority of the projects for the organization or each business unit.
Do you need to provide a single view of the project portfolio for an entire organization? To be honest, I don’t know how to provide enough detail without making people berserk. I do understand how to explain a business unit’s work, but not an entire organization once you have more than a few business units.
Decide How Often to Review Your Corporate Portfolio
If your teams work in an agile way, they will make substantial progress every month, never mind every quarter. How often should you check your strategy?
In my experience, startups and small companies need to review their corporate strategy and portfolio more often than larger organizations do. Make sure you are doing work that advances your organization, not staying in place.
If you are in the midst of a disruptive change in your current strategy, you also need to review the strategy and portfolio more often.
If you are not in the midst of disruptive change, consider a three-to-six-month review of your strategy and portfolio.
Here are my guidelines (not rules) for changing your strategy:
Do not try to overhaul your strategy every three months. That is too much change for the organization. Instead, consider how you can make the smallest possible change to nudge the organization toward the direction you want.
Once you have a reasonable strategy for each business unit, see how to use the project portfolio to nudge changes. If something disrupts your industry or market, feel free to redefine your mission and driving force. Then, update your strategy and ask people to deliver running, tested features, so you know the work is done. You can then try experiments.
Experiments have a hypothesis or supposition, measurements, and a timebox. Let’s look at some examples of experiments. Say you want to experiment with different payment transaction systems for one product. You’ll experiment with one product before expanding all products to use these transaction systems.
For Product 1, you integrate five different payment systems into the buying experience. You measure at least this data:
The number of people who click to add something to a cart.
The number of items in carts. You might have to measure the median as well as the minimum number of items and the maximum number.
The pages where people spend the most time.
The number of abandoned carts.
You might have more data to measure.
Measure this data each day or week, depending on your transaction volume.
At the end of your timebox, you assess the results. You have several choices:
You have learned what you want from the experiment. You end the experiment.
You have more questions. Decide what data to collect and how long to let this version of the experiment proceed.
If you are not sure of something, experiment. Make certain you decide on your hypothesis, your measurements, and your timebox so you can know if you have enough data for your decisions.
Scale with Care
I recommend each group learns how to manage their project portfolio. Then a business unit composed of groups learn how to manage their portfolio. Once each business unit learns, bring the business units together.
You will gain most of the value at the business unit level once the leaders talk and work with each other.
If you are a senior manager, work on your managers’ collaboration skills and goals so they work together. When people have the interpersonal skills and common goals, they can roll up/down the project portfolio. Make sure you do not have incentives that destroy your managers’ abilities to discuss and see common goals. That will be more valuable than rolling up/down the project portfolio.
Now Try This
Ask business units to generate their project portfolio.
Review the portfolios privately, so you can see what people put in them.
Decide if you need to define your strategy in preparation for your first meeting, or if you need to provide guidance about the portfolios for a meeting.
Evolve Your Portfolio
When you shift the focus from “project” to “running, tested features,” you’ll change what your project staff works on. Instead of planning for the future, they plan for the now—to get to “done,” whatever that means for their project.
You’ll find that the management focus changes as well. The way you use and manage your portfolio will be different. You’ll begin to apply a lean approach. Lean approaches work well when you’re having trouble deciding which project is number one. With lean, you don’t have to know about projects; you only need to rank features.
Instead of having to manage the relative ranking of projects, you can manage the portfolio as a backlog of related features. All you need to know is the relative value of each feature and approximately how long it takes your team to finish a feature. Of course, you do have to do a little strategic planning all the time to make sure your vision and strategy match what you’re asking the team to do. You’ll find that it’s easier to plan a little, do a little, check that it’s all coherent, and replan than it is to have to cancel an eighteen-month project that no longer has any value. Right?
Lean Helps You Evolve Your Portfolio Approach
If you don’t have to think about projects anymore, you can use lean and agile approaches to making the portfolio decisions. With the lean principles in mind, you can see that organizing work as agile projects, and using pull approaches to organize the work, provide you with the maximum flexibility in managing the project portfolio.
Review your portfolio. Do you see projects that are contributing to waste, rather than removing wastes? Sometimes that waste arises from how the projects are organized. For example, if your projects are based on everyone multitasking all the time, you have tremendous waste. If you try to define all the requirements up front and implement across the architecture instead of by feature, you will have waste. If the project team does not think in terms of value and finishes the most valuable features first, you will have waste.
If you’re not sure how to apply lean principles to your projects, try stabilizing something about your project work, such as the timebox, queue length, item size, or cost per feature. But you can’t use a waterfall lifecycle at all; a serial lifecycle won’t work. You may be able—with a lot of work—to modify an iterative or incremental life cycle if you keep whatever you’re fixing to a small size. If you’re going to do that, why not use an iterative/incremental or agile life cycle? Agile lifecycles match lean principles. The other lifecycles don’t.
When you choose to stabilize something, such as the timebox, queue length, item size, or cost, you rarely need to make a big decision (Never Make a Big Commitment). And you can avoid having projects. That might seem like a strange thing to say in a book about project portfolio management, but hang in here with me a minute. If you can deliver value every week or two or three or four and have a releasable product as you deliver value, the idea of a project may not make as much sense anymore.
Instead of thinking about projects, you can think about releases: internal and external. If your external releases are always the same as your internal releases, you don’t need to be tied to projects. Instead, you can work based on a fixed time, a fixed size of work, a fixed queue of work, or a fixed cost of work.
Deciding what to stabilize can be tricky.
Choose What to Stabilize
To decide what to stabilize, look at your work now. Are you already working in timeboxes? If not, start there. Projects using any lifecycle can use timeboxes. Moving your projects to work in timeboxes is the easiest start at working to deliver small increments of value that will allow you to reassess each project fairly as you manage the portfolio.
Once you’re working in timeboxes, are your teams able to meet their commitment to what they intend to accomplish in a timebox? My experience is that until teams are allowed to work together for several iterations without changes to the timebox’s content or team makeup, it’s impossible for a team to accurately estimate what they can accomplish in a timebox. If your teams are having trouble meeting their timebox commitments, consider stabilizing the item size.
Once you can reduce item sizes so they are relatively small, you can move to a fixed-size queue of work. Then it won’t matter what project your team is working on.
Stabilizing a feature cost requires small item sizes because it’s impossible for a team to accurately estimate large chunks of work. Short timeboxes help you fix a particular cost and help project teams predict what they can finish in a timebox.
How Does This Work for Hardware Projects?
Just as I explained in Incremental Funding for Hardware, it’s a little more difficult to make these ideas work for a product that has hardware as a piece of the released product. It’s not impossible. Fixing the timebox is easy. Fixing the cost per feature is easy. You may want to conduct another portfolio review meeting just before you commit capital equipment or non-recurring expense (NRE) money. But for the bulk of development, this works for hardware projects as easily as it does for software.
Stabilize the Timebox
When you use an agile life cycle, you define the timebox duration at the beginning of a project. Use the same starting day and duration timebox for each team so you can decide the following at the end of each timebox (or at the end of every x timeboxes): how much value is left in continuing this project (or work or collection of features)?
You can use timeboxes in any life cycle. Timeboxes are ideally a week or two but can be as long as four weeks—any longer, and people lose the focus the timebox provides. You’ll find that shorter timeboxes require little planning, certainly less than a couple of hours. You will use a sequence of timeboxes to help people build a rhythm.
If you move an entire organization to work in timeboxes to decide when to release, make sure the teams meet these conditions: Know what “done” means for each feature. Teams cannot predict and measure velocity if they don’t define “done” for each feature.
Every team must have running, tested features at the end of every timebox. If a team can’t complete some specific independent feature in a timebox, that might be OK. It’s not OK if they break the product. At the end of every timebox, the product must be releasable. That allows the project team to have a stopping point, which mentally frees them to work on the most valuable project next, whether it is this one or not.
Management and the product owners must agree on a minimal set of releasable features. If management and product owners don’t agree, you will never release a product to your customers. Well, you will when some senior manager yells, “Ship the damned thing already,” but that’s not a planned release.
Timeboxes must be short enough so a team doesn’t fall out of its rhythm. That’s a timebox of no more than four weeks, with a releasable deliverable at the end. (I prefer two-week timeboxes with releasable deliverables at the end.) If a team loses its rhythm, it ceases to be productive. Just because you have a timebox does not mean the team will maintain its velocity.
When You Can’t Stabilize the Timebox
If you have to integrate software or hardware from someone else and they are not accustomed to working in timeboxes, you may not be sure how to maintain your timeboxes. In that circumstance, you might be able to maintain a timebox for your work, but not work for the entire product. For example, at the beginning of a timebox, you might assign some tasks that say “Work with a drop from vendor” without a specific size attached to it. In addition, you may have to change your definition of what “done” means for the end of a timebox.
I can’t think of another reason to not be able to maintain a timebox. If the technical staff overcommit to work and can’t finish all of it in a timebox, reduce the duration of the timebox so that they can learn to estimate how much work they can do in a shorter period of time.
Stabilize the Number of Work Items in Progress
Fixing the work size means fixing the amount of work in progress. That can work on two levels: the number of tasks in the process for a given project, what I’ll call kanban-in-the-small, and the number of projects in process, what I’ll call kanban-in-the-large.
Kanban is a system of seeing the work in progress and knowing when it’s time to put more work items in the queue to be worked on. Kanban literally means a signboard, as in Toyota Production System. The team can see the work in progress—one feature and the work yet to do, all on one board.
For example, in all serial life-cycle projects, you have a list of features. Most iterative and incremental life-cycle projects have a similarly long list of features. That feature list changes and tends to grow the longer the project is. In agile projects, there is a product backlog that is reranked for each timebox, and the team takes the next chunk of what they think they can complete off the backlog.
Why is an MMF so important? It’s because that’s the basis of project portfolio management. Projects don’t matter; the set of MMFs you are ready to release is what your customers buy, as we discussed earlier. A completed MMF provides value to the organization.
When a team uses a kanban system, the team limits the number of tasks in progress at any time. At Agile 2007, Arlo Belshee described what he called naked planning, a way to limit what the team sees to no more than seven MMFs. The team works on one MMF at a time. There is no minimum or maximum feature size, but the customer who requests the feature tends to ask for smaller features to limit the time the team is unavailable to work on new features.
You don’t need to have a queue of just seven items as Arlo describes. Your queue can be any size. The key with kanban is that enough people work on one MMF and complete it before taking another feature of the queue. With kanban systems, your project team can even work on multiple MMFs as long as the team can release the product once one MMF is complete. This means the team has to have great source control so the team can work on multiple MMFs and still be able to release as soon as one MMF is complete.
To use kanban effectively, the team must keep a sustainable pace, and someone (or some defined set of people) decides what the ranking of each waiting item is. But the team doesn’t care what they work on. They just take the next item off the list. That’s why you can use kanban for projects as a whole to manage the whole portfolio and for a given project to manage when you complete each feature.
Fix the Number of Tasks In-Process, Kanban-in-the-Small
One way to avoid projects but still manage the portfolio is to stabilize the number of feature sets in the process. Here you can see that one feature set, a minimally marketable feature set, is in progress. That set has seven tasks. Of those seven, four have not yet been started, two are in progress, and one is done. Once all the tasks are complete, the team can release the MMF.
When you stabilize the number of in-process tasks, especially if you are able to define a minimum marketable feature set as a relatively small number of tasks, you see a number of benefits. With so few in-process tasks, people actively work together to complete tasks. Projects complete faster because there’s no (or at least less) wasted work. Because you’re implementing by feature, the team and you can see the project’s progress easily.
Fix the Number of Projects In-Process, Kanban-in-the-Large
Some management teams, even when they’ve ranked the portfolio, have a difficult time assigning teams to just one project until that project is complete. But aside from the benefits to the team of avoiding multitasking, you receive a ton of benefits by fixing the number of projects underway:
You know you are never going to starve a project of its necessary people. That’s because you never assign more projects than you have teams. The teams all learn all the projects. You don’t have to worry about cross-training because the idea of specializing in types of projects goes away.
Developers (or testers or writers or whomever) never have to worry about projects that are like albatrosses. That’s because the team has responsibility for the project, not management. And the team may not be assigned to this project each time a particular product needs more work.
Projects complete faster because there’s no competition from other projects. It’s easy to organize your project portfolio because you and the organization’s leaders define what the organization needs to work on now and what can be postponed until the next evaluation.
Any project with any life cycle can use a kanban queue. It might look different depending on your lifecycle. In the following figure, you can see how an organization that wants three projects in process for one team has queue limits on what’s ready to start (seven stories), what’s in review with the product owner (three stories), what can be in the development and unit test queue (two items), what can be in system test (two), and what can be in final check (one).
If you decide to use a multi-project kanban queue, make all the items for all the projects small and roughly the same size. I like stories of no more than two-team days. I prefer stories that are one day or less to finish.
When you make the items small, the team can maintain a rhythm independent of timeboxes. That gives you more flexibility in what to add to this kanban and helps the team feel as if they can finish work. The team doesn’t feel as if they have a never-ending supply of work, even if you have many MMFs for many projects for one team.
This approach to the project portfolio requires significant discipline from every manager in the organization. As soon as one person tries to push his or her project ahead of another or asks a technical person to multitask, kanban-in-the-large falls apart.
When You Can’t Fix the Work Size
Some projects have an ebb and flow. Some teams have to account for maintenance work or other product support work in their projects. You can still use kanban. As the team completes one MMF, they take their next chunk of work from the queue labeled “Urgent,” for example. Kanban is great for managing a large queue of defects, especially if it’s easy to release the product after each fix. But Kanban is not easy to implement for many teams.
In order to stabilize the amount of work in progress, you have to become accomplished at defining MMFs of roughly the same size. But many product owners, managers, and development teams are not good at estimating the relative size of feature sets. If you’re working on a new, never-been-done-before product, you have never worked in timeboxes, and the team has never tried to estimate separating size from duration, then you may have trouble with kanban. In addition, if your team has few generalists and many specialists, it will be difficult to work on just one MMF at one time.
To fix the queue size for a project, the team needs to create small MMFs of similar size. To fix the queue size for a portfolio, the team should be able to work on any product, and the people ranking the requirements have to define MMFs of relatively small size. If your organization can’t do that, you won’t be able to stabilize the work queue.
Fix the Queue Length for a Team
A related option to fixing the number of in-process tasks for a project is to fix the number of in-process tasks for a team. Each task takes as long as it takes —although this works well when you have relatively smaller tasks and works less well as the task size increases. At Agile 2007, Arlo Belshee discussed the idea of what he called a Disneyland queue. With a fixed-length queue (he uses a queue of seven items) and historical cycle time, the team estimates a “your time from here” estimate for the last item in the queue:
Note that the team doesn’t estimate each item in the queue. The product owner, customer, product manager—whoever is in charge of ranking requirements—is the one who has some idea of how big each item is and, more important, how valuable each item is. The team doesn’t estimate the item until they start it.
Of course, if they realize this item is much bigger than other items, they let the product owner know. The product owner can then work with the team to break down the large task into smaller user stories. The product owner reranks all the user stories. Then, the entire team works on the first item in the queue until it’s done, as in releasable. Then, the team takes the next item off the queue to work on together.
Not all items need the entire team. In that case, the first item takes all precedence, and as team members are available, they work on the next item. This is a similar team assignment as in Rank with Business Value Points, except that here, the team is assigned to one task in the queue, not a whole project. If your items are not roughly the same size, you will have trouble with cycle time as a prediction tool.
When You Can’t Fix the Queue Length
Fixing the queue length is great for organizations and teams that are accustomed to working in a rhythm and in small chunks. If your team or your management is not accustomed to implementing by feature or a rhythm to the projects, you are not going to be able to fix the queue length. Not only will your management have to make a binary decision about which feature is done next, but the feature size also has to stay small. Stabilizing the queue length requires substantial discipline from everyone: the product owner, the management, and the technical staff.
When You Need to Fix Cost
Well-meaning people have used waterfall life cycles as a way to control costs. They thought that if they monitored the documents throughout the life cycle, the documents would have some relationship to the product. We know that to be untrue. But serial lifecycles persisted, and many managers derive (undeserved) comfort from them.
One of the big problems in a waterfall project is that you can’t make the decision to kill or change the project until very late in the project’s lifecycle. So, when you need to fix cost, you want a life cycle that allows you as much flexibility making cost decisions as possible. That means agile.
If you need to work on a fixed-price contract, have the customer rank the requirements, explain how velocity works, and show the same kinds of data as you would in a portfolio evaluation review. Now, you as the development group work in a rhythm to finish as much of the work as possible. Your best bet is to fix a timebox of no more than two weeks, as in Stabilize the Timebox.
Management Changes When You Stabilize Something About Your Projects
Fixing something about your projects has a sobering effect on management. Once you’ve made the decision to fix a timebox, you can’t change it. You can’t reduce or increase the timebox duration without creating obstacles for the team, because you’ve destroyed their velocity as well as removed their ability to measure it. You can’t ask people to put in overtime for the same reason.
Once you’ve prevented a team from measuring their velocity, they have no idea where they are, and neither do you. You can’t ask for multitasking either. You can’t keep large projects in the pipeline without breaking them down into their feature sets (not architectural components, but smaller sets of features).
What you get is management “discipline.” It’s the discipline to manage for results, not for activities. It’s the discipline to make a decision and keep it, as long as it still fits the strategy. It is wonderful. But you have to be a disciplined manager to do this. Not only do you get management discipline, but you also get team discipline to focus on one thing at a time until it’s done.
Now Try This
Review your portfolio. Do you see projects that are contributing to waste, rather than removing wastes?
What can you stabilize your projects? Is it possible to fix the size of the queue of tasks? Or the size of the items in the queue?
Have you or other managers resisted stabilizing something about your projects? Write down why that works for you.
If you’ve tried this, what kinds of management costs have you seen?
Measure the Essentials
You could try any number of measures to evaluate your projects: duration, cost, earned value, and consumer ROI, to name a few. But these measurements alone don’t provide you with a useful measure of how much value the project is contributing or could contribute to the organization.
You want to measure enough about projects to know whether they are running smoothly so you can make the commit/kill/transform decision. And you need to know whether the project is still returning value to the organization to decide whether you should commit to the next set of features for the project.
Your measurements help you know whether the project is returning value to the organization. They tell you how smoothly the project is running. And they can provide a baseline for seeing change. In this blog, we will consider possible measures that will help you know whether a project is making progress and the value it provides to the organization.
What You Need to Measure About Your Projects
For projects, you need to measure the completion of running, tested features over time, in other words, the team’s velocity over time. That’s all you need to measure—assuming your measures are correct. If your team doesn’t actually finish features, as in done-done-done, you’ll need other measurements, like defects and schedule dates.
When I say done-done-done, I mean that the product is working and documented enough that a customer could use it. The code is checked in, the developers and testers have planned and run “enough” tests, the documentation exists and is correct, any hardware is working, and the code has passed enough testing that the project team has confidence in it and the product is releasable for a customer to use.
You don’t need to measure the number of defects, although knowing those will help you determine whether this project is sufficiently valuable as is. You don’t need to measure start and end dates, although you may want this data for organizing the portfolio. You need to know how much this team can churn out in a given time period.
I wish I could tell you that you could compare two teams’ velocities and know which one was more productive. Sorry, comparing teams, especially those working on different projects, is like comparing oranges to frogs. The projects the teamwork on, how the team estimates, the environment in which the teams work, and how frequently the team has to work toward norming are all factors that prevent you from comparing teams.
Although it’s tempting to measure projects completed per unit time, measuring that is a surrogate for the true measurement of what your users and customers want from you—completed features that work. For a lean or agile approach to managing the portfolio, consider these measures:
The team’s velocity of running, tested features and the historical velocity chart (team capacity over time).
The amount of work in progress. The more work in progress, the less lean you can be.
Obstacles preventing the team from moving faster, such as defects, insufficient automation, and incomplete stories. Obstacles are risks to the project and tend to be examples of technical debt. Product backlog burnup chart so you can see where in the product backlog the project is. If you measure cost, cost of the project since the last portfolio evaluation and the total project cost to date.
Because these are all project measures, you need to be careful about what and how you ask the team to measure themselves. Make sure you ask from a position of helpfulness and curiosity. If you use these measures to beat the team or punish them, they will game the measures in any way they can. That will prevent you from making good portfolio decisions.