Russ Koesterich, who is currently responsible for asset allocation and risk management for BlackRock’s largest investment team (managing about $80 billion), has written a book for financial advisers. Portfolio Construction for Today’s Markets: A Practitioner’s Guide to the Essentials of Asset Allocation (Harriman House, 2018) explains, in general terms, how to combine assets in a risk-controlled manner.

Portfolio construction is especially daunting in a low interest rate environment. Low rates have not only reduced income from bonds in a portfolio. Many bond funds, searching for yield, have gone out in duration, increasing their riskiness. “They will experience larger than typical losses when rates rise.” In brief, bonds are not playing their traditional role: they are providing less income, and they are becoming a less reliable way to manage volatility.

In separate chapters Koesterich discusses portfolio constraints (the most important of which is risk), diversification, factors, and how to make a stab at forecasting returns using, among other inputs, historical returns and expected risk (as “the second sanity check”). Only then is it time to build the portfolio, described in a chapter titled “Some Assembly Required.”

Koesterich considers several approaches to constructing a workable portfolio, in increasing degrees of viability: minimum risk, maximum return, maximum Sharpe ratio, targeted return while minimizing risk, and maximum return within a particular risk budget. The last two approaches result in strategic portfolios. “Think of the strategic portfolio as the portfolio best suited to the investor’s needs over the long term. It provides a baseline allocation consistent with investment goals. This is the portfolio the investor is trying to beat when they decide to get fancy and time the market [tactical asset allocation]. If the investor finds that they can’t really time the various asset classes to produce better results, these strategic portfolios are the default to revert to.” If, however, the investor wants to make tactical adjustments, thereby tilting his portfolio away from its long-term, strategic allocation, he might consider changing his risk budget, “raising it when expecting particularly high returns and lowering it when concerned about a bear market.”

Five rules can guide the process of building a portfolio: (1) start with a goal, (2) be both explicit and parsimonious when it comes to constraints, (3) be honest about risk, (4) diversify, and (5) remember the denominator: always think in terms of risk-adjusted returns.