Portfolio Construction - From Asset Allocation to Position Sizing
By EC Assets Research Team, Portfolio Strategy · Published · Updated
Portfolio Construction: Portfolio construction translates strategic objectives into specific position sizes, factor exposures, and risk budgets. It sits between asset allocation (what categories to own) and risk management (how to control outcomes).
What Portfolio Construction Is
Portfolio construction turns investment objectives into a specific set of weights, risk budgets and rules. It sits between strategic asset allocation, the long-term choice of asset classes, and day-to-day risk management. Its inputs, expected returns, volatilities, correlations, costs and liquidity, are all uncertain, so the aim is a portfolio that behaves acceptably across plausible assumptions rather than one that is optimal for a single forecast.
How It Works
Three frameworks dominate institutional practice. Mean-variance optimisation, from Modern Portfolio Theory, maximises expected return for a given volatility but depends heavily on return forecasts. Risk-based approaches such as risk parity allocate risk rather than capital and need no return forecasts. Factor-based construction, the logic of factor investing, builds the portfolio around exposures such as value, momentum or quality rather than asset classes.
All three rely on the same measurement: how much of the portfolio's risk each position contributes. With weights w and covariance matrix Σ,
$$\sigma_p^2 = w^\top \Sigma, w, \qquad RC_i = \frac{w_i,(\Sigma w)_i}{\sigma_p^2}, \qquad \sum_i RC_i = 1$$
Risk contributions add up to the whole and can be negative for a position that hedges the rest. Maillard, Roncalli and Teiletche (2010) define the equal risk contribution portfolio, in which every asset contributes the same share; for two assets it simply weights each by the inverse of its volatility.
In practice the process runs in a sequence: set objectives and constraints such as return target, drawdown tolerance, liquidity and regulation; decide the risk budget across asset classes or factors; estimate inputs with shrinkage or scenario ranges rather than point forecasts; build the portfolio with weight limits; and stress test the result before trading, with execution costs and taxes in view.
Correlation drives these numbers. With ten assets of equal volatility and zero correlation, equal weights cut volatility to 1/√10 ≈ 31.6 percent of a single asset's; with perfect correlation they cut it not at all.
Worked Example
Equities have 16 percent volatility and government bonds 7 percent. A 60/40 portfolio's risk contributions depend on the stock-bond correlation:
| Stock-bond correlation | Portfolio volatility | Equity share of risk | Bond share of risk |
|---|---|---|---|
| -0.45 | 8.71% | 105.6% | -5.6% |
| 0.00 | 10.00% | 92.2% | 7.8% |
| +0.28 | 10.73% | 86.6% | 13.4% |
A negative bond contribution means bonds reduce total risk.
Whatever the correlation, a portfolio that looks balanced in capital is dominated by equity risk, so its results are largely a bet on equities. A two-asset risk parity portfolio instead holds 7 / (16 + 7) ≈ 30.4 percent in equities and 69.6 percent in bonds, so each contributes half the risk. Its volatility is only 5.11 percent at a correlation of -0.45 and 6.89 percent at zero, so reaching a 10 percent volatility target requires leverage of about 1.96 and 1.45 times respectively. The risk budget tool applies the same logic to position sizes.
When It Applies (and Limitations)
Forecast sensitivity. Mean-variance weights swing with small changes in expected returns, so practitioners constrain weights, shrink estimates or use resampling.
Leverage and its costs. Risk parity needs leverage to reach equity-like returns. Asness, Frazzini and Pedersen (2012) argue that many investors' reluctance to use leverage is what makes low-risk assets attractive, but leverage adds financing costs and the risk of forced deleveraging.
Correlation regimes. Both approaches lean on the stock-bond correlation. When inflation pushes stocks and bonds down together, as in 2022, the bond allocation cushions much less and leveraged bond positions add to losses.
Rebalancing has a shape. Perold and Sharpe (1988) show that rebalancing to constant weights is a concave strategy: it sells winners and buys losers, gaining in markets that oscillate and lagging in markets that trend. Buy-and-hold and portfolio insurance sit at the other end of that spectrum.
Costs eat theoretical gains. Frequent re-optimisation and tight rebalancing bands generate turnover, and the spreads, market impact and taxes it causes can exceed the improvement in expected risk-adjusted return that the changes promised.
More positions are not always more diversification. Statman (1987) found that around 30 to 40 stocks capture most of the available diversification in an equity portfolio; beyond that, what remains is market risk.
Why It Matters for Institutional Investors
Risk budgets. Expressing allocations as shares of risk, not capital, shows where a portfolio's outcomes will come from and whether that matches the investment committee's intent.
Governance of rebalancing. A written rebalancing policy, with bands or calendar dates and clear exceptions, prevents decisions being taken under stress, when the pressure to abandon the plan is greatest.
Stress testing. Running the portfolio through historical episodes and hypothetical shocks, with correlations and volatilities set at stress levels, shows losses that a volatility-based risk budget alone would understate.
Implementation choices. Currency hedging, tax efficiency and liquidity planning for illiquid commitments all change realised outcomes and belong in the construction process, not after it.
Connecting the layers. Construction links strategic asset allocation to the positions actually held, and makes the trade-offs between return assumptions, risk and robustness explicit.
References
- Markowitz, H. (1952). Portfolio Selection. Journal of Finance, 7(1), 77-91.
- Maillard, S., Roncalli, T., & Teiletche, J. (2010). The Properties of Equally Weighted Risk Contribution Portfolios. Journal of Portfolio Management, 36(4), 60-70.
- Asness, C. S., Frazzini, A., & Pedersen, L. H. (2012). Leverage Aversion and Risk Parity. Financial Analysts Journal, 68(1), 47-59.
- Perold, A. F., & Sharpe, W. F. (1988). Dynamic Strategies for Asset Allocation. Financial Analysts Journal, 44(1), 16-27.
- Statman, M. (1987). How Many Stocks Make a Diversified Portfolio? Journal of Financial and Quantitative Analysis, 22(3), 353-363.
Frequently asked questions
What is risk parity?
An approach that allocates risk rather than capital equally across asset classes, so each contributes the same share of portfolio volatility. Because bonds are less volatile than equities, a risk parity portfolio holds more bonds and usually applies leverage to reach a target level of risk.
How do institutions choose between mean-variance and risk parity?
Mean-variance optimisation needs expected returns, which are hard to estimate, and tends to produce concentrated portfolios. Risk parity avoids return forecasts by assuming roughly similar risk-adjusted returns across asset classes, but depends on leverage and on correlations holding. Many institutions combine elements of both.
What is the correlation problem in stress?
Correlations between risky assets tend to rise in selloffs, so diversification that looks ample in normal markets shrinks when it is most needed. Stress tests with higher correlations, and attention to the stock-bond correlation regime, give a more realistic picture than long-run averages.
How often should portfolios be rebalanced?
There is no single answer. Calendar rebalancing is simple; threshold rebalancing trades only when weights drift beyond set bands, which usually lowers turnover. The choice balances transaction costs and tax against the risk of drifting away from the intended allocation.
How many holdings does a diversified portfolio need?
Fewer than many investors assume, as long as they are not highly correlated. Statman (1987) found that around 30 to 40 randomly chosen stocks capture most of the diversification available in an equity portfolio; beyond that, the correlated market risk that remains cannot be diversified away.
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