So when we think about portfolio construction, Vanguard has four key principles that we believe underpin successful portfolio construction. So the first of those is goals. So an investor will have personal goals which they'll want to achieve through investment - so an example of that might be retiring by a certain an age - and then married with that will be portfolio goals. So when constructing the portfolio making sure that the goals of the portfolio meet those personal goals.

The second one is around balance. So within a portfolio you'll be allocating to different asset classes that might be equities, bonds, so it's really important to consider do you have balance within those asset classes? So are you well diversified? Do you have the right allocation between equities and bonds as well? The third one is cost. So costs are really important to investment outcomes because the higher the cost, the less investment return you get to keep, everything else equal.

So when thinking about portfolio construction, we suggest thinking about how much are you paying for the portfolio that you've constructed and are you happy with that in terms of the value that you expect to get? And then the fourth one is around discipline. So you've put in place a portfolio that meets the client's goals. It's balanced, it's low cost, and then with those in place, can the client have the discipline to then hold that portfolio for the long term?

Because our research shows that by holding the portfolio for the longer term and sticking to a client's investment objectives, they have a better chance of investment success. So broadly, when we think about portfolio construction, those four key principles play a really important role in constructing a portfolio that will result hopefully in the best investment outcome for a client.

So digging a bit deeper into the principle of goals, it's the first thing you do when constructing a portfolio is think about what are the goals of the client or the investor that you're working with. And those personal goals will vary hugely for each individual and they'll vary at different points of time as well in an individual's life. So you might have a client that wants to retire by 65 and they've got a 40 year time horizon.

It could be a client who wants to save for children's education or even perhaps a shorter term goal. So a client might want to have a house deposit in the next few years. So when you think about the goals of a client, they will vary and the time horizon will vary as well. So when constructing a portfolio that meets their needs, it's really important to take those into account.

Then we're looking at the portfolio’s goals. There's a number of different types of goals you dould have for a portfolio. So one could be wealth accumulation. So for the retiree, maybe they want to accumulate that wealth and have a certain pot of money by the age of 65. But there are other types of goals that they can have as well.

It could be a certain amount of income they want or they might want to get a certain level of return to help them achieve a goal. So there's different types of personal goals and portfolio goals that need to work together in order to be successful for the client. Once the portfolio’s goals have been set, the next phase is look at the balance of the portfolio.

So within a portfolio you'll be allocating to different asset classes and it's important to consider how diversified those asset classes are, and the other thing to consider is any unintended biases that you might have within a portfolio. So you might drill down and look at your value equities versus growth equities, for example, or different types of fixed income.

So looking at the balance of the portfolio as a whole and looking at the composition that you've created from the number of funds that you’ve used, it’s really important to look at an overall picture because then it gives you a sense of how might I expect this portfolio to perform in the future.

Anyone who's worked with Vanguard before or knows of Vanguard will know how important we think costs are to investment outcomes. They’re hugely important because the higher the cost, the lower the investment return or outcome you're going to get at the end of your investment period, everything else equal. And so looking at cost is a really kind of integral part of portfolio construction. Now there’s different types of cost to consider when constructing a portfolio.

So the first one is around the fee that you're paying for, say a fund, so the ongoing charges fee, and that's a very obvious fee that most people are aware of. And then there's other types of costs as well within a fund that are less visible but still there, things like transaction costs or taxes, and they'll vary depending on what asset class you're investing in, what country you're investing in.

So it's important to understand all the different costs that go into a portfolio so that you can make a decision about what level of costs are you happy to pay for. The fourth principle is discipline. So when constructing a portfolio, it's important that a client can hold it for the long term. And if you’ve built a portfolio using certain goals, balance within the portfolio and also taking into account cost, then the portfolio should be designed to be held for the long term.

Now there’s some different things that go into whether a client can hold something for the long term and emotion comes into that a lot. How happy they feel about the markets going up or the markets going down. And so an investor's ability or willingness to bear loss during the time of their investment is also really important to take into account, because we want a client to be able to hold that portfolio and stay the course for the long term when they're investing.

So a market-cap weighted approach to investment involves allocating your assets based on the size of the underlying market. So it's probably best described with an example. If you have an equity portfolio and you were wanting to allocate using a market-cap approach, then you would allocate your largest amount of your capital to US equities because that's the largest equity market in the globe.

And so you use the size of those markets to determine what your allocation is to the underlying assets within those asset classes. So investing using a market-cap approach is a very diversified way of investing. It gives you a very broad exposure to lots of different equities or bonds within each of those asset classes, and it can be implemented in quite a low cost way because many people use say passive investments to get exposure to those markets using that market sizing.

Now, market-cap approach works really well, it’s a really good starting point for an asset allocation, but sometimes investors might have different preferences they might want to express that you might want to use a different portfolio construction technique for. Some examples of that might be you want to include an active fund within your portfolio, you might want to have, say, an income target or you might have ESG preferences that you want to put into that portfolio.

So if you have those types of preferences, then again, market-cap is a great place to start and works well for many, many investors, but there are other ways as well that you can implement portfolios which we’ll talk about in the next video.