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Portfolio Construction

Pen paper and calculatorTim Farrely's company (farrely's) prepares long term financial forecasts and uses those to produce model asset allocation models. We subscribe to his forecasts and use various tools to assist us build client's portfolios. Farrely's philosphies are consistent with ours and can be summarised as follows.

Portfolio Construction Principles

Long-term return forecasts can be a vastly superior guide to the future than historical returns.

  • Breaking returns into the three components income, income growth, and the effect of changing valuation ratios can provide clear insights into future returns
  • Long term forecasts of asset class performance are generally far more reliable than short term forecasts, and infinitely more reliable than historical extrapolations
  • Using past sector performance as a guide to the future is worse than meaningless. It is generally a counter indicator.

Risk, like beauty, is in the eye of the beholder. It is best assessed with the investor in mind.

  • All risks that are relevant to the investor must be considered.
  • Most risks faced by private investors can be grouped as affecting long term real returns, liquidity or peace of mind.
  • The key risk faced by most investors is having insufficient long-term, real returns to satisfy their cash flow needs
  • The most important risk to any investor is rarely associated with a Greek letter
  • The one risk that investors should not have to worry about is someone else’s business risk

Portfolio’s should be built to meet investor cash flow needs

  • The main driver of portfolio construction should be meeting investors cash flow needs with an acceptable level of certainty
  • Portfolios don’t have to be theoretically perfect, highly efficient and robust will do.
  • Taxes, transaction costs and fees can represent over 50% of returns, they must be factored in to all decisions.
  • Business risk should never be the key driver of portfolio construction.

About Tim Farrely

In addition to being Principal of farrelly's, Tim is also a Visiting Fellow at the School of Finance and Economics at the University of Technology Sydney, and is on the Editorial Board of the Journal of Portfolio Construction. Tim is a sought after speaker and a frequent presenter at Australian FPA annual and state conferences on a range of topics including capital market history, risk management, and portfolio construction. He chairs the Inquisitor Program at the Portfolio Construction Forum.

Prior to founding farrelly's in 2004, Tim was an Executive Director of Macquarie Bank Ltd, and Director of Macquarie Investment Management Ltd.(MIML). At various times during his 14 years at Macquarie he sat on the MIML Asset Allocation and Risk Committees, and was responsible for distribution of the Bank's products through third party financial planners and stockbrokers. While at Macquarie, Tim was responsible for the booklet 'Understanding Risk to Meet Your Financial Goals', which is jointly published by Macquarie and the FPA and has become an industry standard, and the Long Term Forecasting program in 2000 which foreshadowed the bear market in US equities. Between 1981 and 1986 Tim was head of research for the Monitor Money Corporation, where he was responsible for asset allocation and manager selection.

He has an MBA (Distinction) from the Harvard Business School and a Bachelor of Engineering (Met) from the University of Melbourne, where he was awarded the J.Neill Greenwood Medal.

A subscription is required to access the really good research on his website but you may still find items of interest.

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