Once an Asset / Liability profile has been constructed, an investment portfolio is designed.

The following four steps are used in designing a portfolio:

• Deciding which asset classes to include and which to exclude from the portfolio.
• Deciding upon the normal, or long term, weights for each of the asset classes allowed in the portfolio.
• Tactically altering the investment mix weights away from normal in an attempt to capture excess returns from short-term fluctuations in asset class prices.
• Selecting individual securities within an asset class to achieve superior returns relative to that asset class (security selection).

Steps 1 and 2 involve designing an investment policy and strategy. Steps 3 and 4 involve active investment management by tactically altering the portfolio to benefit from a perceived advantage.

Studies have shown that 93.6% of the variance of investment returns are due to the investment policy and strategy decisions and the remainder from tactical asset allocation and security selection

When developing the asset mix, the liability time horizon in Phase One is matched against an investment time horizon. Frequently, a premium is paid in the long term for reducing risk in the short term. As the time horizon is extended, risk is reduced for all assets, but the more volatile the asset in the short term, the greater its volatility will decrease as its investment horizon is extended. As can be seen in the chart, at the 20 year investment horizon, stocks are no more volatile than treasury bills, but their returns are substantially higher. (Note that there are more subtleties to this concept than are being conveyed in this graph).

In addition to diversifying over time, risk can also be reduced by diversifying across assets. Asset allocation involves selecting a number of asset classes and determining their optimal mix. The returns, risks, and constraints in Phase One are combined at this point to determine this optimal mix.In the graph below, the history of the Canadian, U.S. and International equity markets is shown.

By combining the Canadian and U.S. markets, and the Canadian and International markets, two curves are generated. At the bottom of the graph is a portfolio with 100% Canadian equities. While this is the portfolio with the lowest return, it is not the portfolio with the lowest risk. The portfolio with the lowest risk is a 70/30 Canadian/Internationalmixture. If the investor can only purchase Canadian and American equities, then the portfolio with the lowest risk is the one with a 70/30 Canadian/U.S. combination.

The curve formed from the minimum risk point to the maximum return point is called an efficient frontier. This curve is the maximum return a portfolio can achieve for a given level of risk and predefined costs and constraints. While it is possible to have a portfolio below the efficient frontier, it is not possible for one to exist above the frontier.

The main objective of Phase Two is to determine the point along the efficient frontier which meets the investor’s optimal risk, return, cost and constraint profile.

Once an investment strategy is developed, the investor must decide whether to attempt to add extra value through some active management. Too often, investors segment the active versus non-active management decision into the two extremes of very active management and indexing. Instead, the investor should focus on where the varying degrees of active management have a chance of adding value. The possibility of adding value in the U.S. Treasury market is very slight, while real estate investing requires an investor who is very familiar with a local market.

Once the active versus passive management decision is made, then investment tactics are decided or fund manager(s) selected.