Glossary: Portfolio Construction Terms

Difficulty: Beginner Published: 2025-12-28

This glossary defines 28 essential terms for building and managing diversified portfolios. Each entry provides a one-sentence definition with quantified thresholds, historical data, or concrete examples. Portfolio construction principles are grounded in Modern Portfolio Theory (Markowitz, 1952) and factor research (Fama & French, 2015).

Terms

Asset Allocation: The division of a portfolio across asset classes (stocks, bonds, cash, real estate) based on goals, risk tolerance, and time horizon; 60/40 (60% stocks, 40% bonds) is a common balanced allocation.

Benchmark: A standard index (S&P 500, 60/40 portfolio) against which portfolio performance is measured to assess whether active decisions add or destroy value.

Core-Satellite: Portfolio strategy combining passive core holdings (80-90% in broad index funds like VTI) with active satellite positions (10-20% in sector tilts or factor funds).

Diversification: Spreading investments across multiple assets, sectors, or geographies to reduce single-position risk; a 3-fund portfolio (US stocks, international stocks, bonds) is diversified.

Dollar-Cost Averaging (DCA): Investing fixed dollar amounts at regular intervals (monthly, quarterly) regardless of price, reducing timing risk and emotional decision-making.

Drift: When asset allocation deviates from target due to market movements (stocks rally from 60% to 70% of portfolio), requiring rebalancing.

Drawdown: Peak-to-trough decline in portfolio value during a loss period; maximum drawdown measures worst loss experienced (e.g., -22% in 2022 bear market).

Equity: Ownership stake in a company via stocks; equities provide growth potential but higher volatility than bonds (15% annual standard deviation versus 3.5% for bonds).

Expense Ratio: Annual fee charged by mutual funds or ETFs as percentage of assets; VTI charges 0.03%, actively managed funds average 0.75%-1.5%.

Factor Investing: Tilting portfolio toward stocks with specific characteristics (value, quality, momentum) that historically outperform; value factor returned 4.8% annually over growth (1927-2023).

Fixed Income: Bonds and other debt securities that pay regular interest; fixed income provides stability and income, lower volatility than stocks.

Glide Path: Automatic asset allocation shift in target-date funds, moving from stocks to bonds as retirement approaches (e.g., 90% stocks at age 30 → 40% stocks at age 65).

Index Fund: Mutual fund or ETF tracking a market index (S&P 500, total stock market) via passive replication; 89% of active funds underperform index funds over 15 years.

Market-Cap Weighting: Index methodology weighting stocks by market capitalization (price × shares outstanding); Apple at $3 trillion gets larger weight than smaller companies.

Modern Portfolio Theory (MPT): Framework developed by Harry Markowitz (1952) showing diversification reduces risk without sacrificing expected return by combining uncorrelated assets.

Passive Investing: Buy-and-hold strategy using index funds, minimizing trading and fees; passive investors accept market returns rather than attempting to beat the market.

Position Limit: Maximum allocation to single stock or sector (e.g., no more than 5% in any one stock, 20% in any sector) to prevent concentrated risk.

Rebalancing: Selling outperforming assets and buying underperformers to restore target allocation; rebalance when asset drifts >5 percentage points or annually.

Risk Budgeting: Allocating portfolio risk (volatility) across assets to achieve desired risk level; 60/40 portfolio budgets 85% of risk to stocks, 15% to bonds despite 40% bond allocation.

Risk Tolerance: Maximum portfolio loss an investor can endure without panic-selling; measured by willingness to hold during -20% to -50% drawdowns.

Sector Rotation: Tactical strategy shifting between economic sectors (technology, healthcare, energy) based on business cycle; 87% of sector rotation strategies fail to beat market (Vanguard, 2022).

Sharpe Ratio: Risk-adjusted return metric: (Portfolio Return - Risk-Free Rate) / Volatility; Sharpe >1.0 is excellent, 0.5-1.0 good, <0.5 poor.

Target-Date Fund: All-in-one fund automatically adjusting allocation from stocks to bonds as target retirement date approaches; Vanguard Target Retirement 2050 holds 90% stocks, shifting to 40% by 2050.

Tax-Loss Harvesting: Selling investments at a loss to offset capital gains taxes, reducing tax liability while maintaining market exposure via similar replacement securities.

Three-Fund Portfolio: Simplified diversified portfolio: US stocks (VTI), international stocks (VXUS), bonds (BND); covers global equities and fixed income with three holdings.

Tracking Error: Volatility of difference between portfolio returns and benchmark returns; 2-4% tracking error indicates diversified portfolio with modest tilts, >6% suggests concentrated bets.

Total Return: Portfolio performance including price appreciation, dividends, and interest; total return = (Ending Value - Beginning Value + Income) / Beginning Value.

Volatility (Standard Deviation): Statistical measure of return dispersion indicating risk; S&P 500 volatility is 15% annually, meaning returns typically vary ±15% from average in two-thirds of years.

Updates

This glossary will be updated as portfolio construction methods evolve and new terms gain adoption in the investment community.

References

Fama, E., & French, K. (2015). A Five-Factor Asset Pricing Model. Journal of Financial Economics.

Markowitz, H. (1952). Portfolio Selection. Journal of Finance.

S&P Dow Jones Indices. (2023). SPIVA US Scorecard: Active Fund Performance vs Benchmarks.

Vanguard. (2022). Sector Rotation Strategies: Evidence from US Markets.