The strength of any wealth management plan is heavily dependent on an intelligent and well-maintained portfolio. Careful portfolio construction to get the best for each client is an in-depth and comprehensive process, not to take lightly. The client and their wealth manager must consider a great amount of preliminary information pertaining to both the investor and the current economic environment. The wealth manager would then use this information to construct a tailor-made portfolio that best suits the investor.
While the best path to portfolio construction means something different in almost all cases, there are some best practices that are wise to abide by. Here are some of the essentials of quality portfolio construction.
First, we start with some questions.
What Are Your Investment Goals?
The range of possible financial goals an investor can have is endless. It’s one of the reasons this question is so important.
Consider the two following investors. Jim, a 60-year-old husband and father, is planning on retiring and paying for his child’s college tuition in the next five years. Jim is sure to have quite a different set of values from Andy, who is single and a recent college-graduate. In each case, a quality portfolio is a vital part of meeting their investment goals. However, these two investors want and need very investment strategies.
The goals of the investor influence just about every aspect of portfolio construction, from asset allocation to investment management style.
The need for an individualized and personal approach to portfolio construction is something that the best wealth management firms understand. For people looking to maximize long-term growth while making their day-to-day lives easier, finding the right wealth manager is important.
What Is Your Risk Tolerance?
For better or for worse, an element of risk is a necessary part of investing.
The answer to this question comes from a range of influences. It is another key factor in developing the right investment strategy. Everybody is different, and so are their risk tolerances.
Some people are totally content with the possibility of losing money if it means the potential for large growth.
For others, anything more than the smallest amount of risk adds an unnecessary element of stress to their lives. Hence it’s important to find a level of risk that matches one’s financial goals and is also comfortable.
Everyone would like to maximize their returns each year, but the greatest returns are associated with the greatest risks. This relationship is known as the risk-return tradeoff. Understanding this concept means understanding one thing. And that is: the goal of successful strategies is not to eliminate risk entirely, but to optimize the level of risk for each unique case.
To use the example from above, Jim, the soon-to-retire father, may have more incentive to protect his assets and therefore have a lower level of risk in his portfolio. The recently graduated Andy, however, may be less dependent on his assets and therefore willing to take higher risks in hopes of higher returns in the future.
What’s Your Timeline?
Another important aspect of portfolio construction is determining time horizons. Time is an integral variable in any investment strategy.
How long do you have to achieve your goals?
Are you planning for retirement or are you trying to secure wealth for successive generations?
Maybe you’re planning to make a down payment on a house in a year’s time. Your time horizons heavily influence which types of investments should build your portfolio.
All investments have a time horizon, or length of time before the investment is liquidated. You would typically measure a time horizon in years, but some are as short as seconds. Long-term goals may benefit from investments with a longer time horizon. Long-term investments have the benefit of being able to offset short-term losses with long-term gains. These lend themselves to a more aggressive portfolio, or one with higher risk.
Three Elements of Portfolio Construction
1. Asset Allocation
This is widely considered to be one of the most important aspects of portfolio construction. Asset allocation is an investment strategy that distributes your assets according to your goals, risk tolerance, and time horizons.
There are three main asset classes, each with their own levels of risk and return.
- Stocks (equities) – Equities usually have the highest amount of risk and the highest return potential. With a high level of volatility, they can sometimes experience dramatic short term losses. But long-term gains generally overcome these short term losses. Investors with longer time horizons are those who benefit the most from this asset class.
- Bonds (fixed income) – The level of risk associated with bonds is lower than those of stocks, but so are the returns. This tradeoff can be especially useful to investors with shorter time horizons where the lower risk is worth the more modest returns.
- Cash and cash equivalents – This is the asset class with the lowest risk of loss and is considered the safest form of investment. Naturally, it’s also the class with the lowest returns. Types of investments that fall in this category include savings deposits, money market funds, certificates of deposit, and treasury bills. Many of these investments even have their losses guaranteed by the federal government.
Alternatives
The three asset classes above are the most common and generally the most useful in constructing a healthy portfolio. However, there are some other options that can be appropriate in the right circumstances. They include real estate, private equity, and precious metals or other commodities. Each of these alternative investment categories carries its own level of risk and potential for return.
Aggressive vs. Conservative
Allocating your assets in the proportions best suited to your individual needs will determine how aggressive or conservative your portfolio is.
Basically, a more aggressive portfolio is one that has a higher level of risk. This means allocating a higher proportion of funds to equities rather than bonds and other fixed-income securities. A moderately aggressive portfolio may fit an investor with an average risk tolerance whose investing goals have a longer time horizon.
On the contrary, a more conservative portfolio will tolerate a lower level of risk and therefore reap more modest returns. The goal of a conservative portfolio is to protect its value. Investing more in bonds than stocks is a basic example of a conservative investment strategy.
2. Choosing Assets
The three asset classes listed above are also made up of subclasses. After deciding on how to best allocate your assets between the classes, the work of choosing the specific assets begins. This is an important part of the process.
It’s necessary to evaluate the quality and return potential of each investment before buying. Deciding the percentage of funds you wish to dedicate to bonds is an important step. But choosing the right bonds to invest in is equally important.
The following asset subclasses all have their own levels of risk and return potential.
Stocks
- Large-cap stocks – These are stocks in larger, well-established companies. Due to their size, these stocks are generally considered safer investments. However, they offer lower growth opportunities than stocks in small or emerging companies.
- Mid-cap stocks – These are stocks in mid-sized companies that are often fairly well known. The advantage of purchasing stock in mid-cap companies is a higher growth potential than in large-cap stocks. These companies also tend to fare better during turbulent economic climates than smaller companies.
- Small-cap stocks – These are stocks in smaller companies that aren’t as well known. Small-cap stocks can be attractive for the large growth opportunities they boast. Historically they have outperformed large-cap stocks. This comes at a price, though. The risk with investing in small-cap stocks is significantly higher because the companies are newer and therefore subject to greater losses.
- International or domestic stocks – Stocks in foreign or domestic companies. Investing in foreign stocks can be a good way to diversify your portfolio. By making investments in both foreign and domestic markets, you can protect yourself from underperforming stocks in multiple economies.
Stocks that fall into these three categories can also be split up into value stocks and growth stocks. Value stocks are temporarily priced lower than their true value. Growth stocks belong to companies that are growing rapidly. The ability to identify these stocks and understand their value in a portfolio is a major advantage.
There are also many different types of bonds you can invest in.
When differentiating between different types of bonds, it’s important to consider the current interest rate environment and the issuer of the bond. Bonds can be issued by governments, agencies, and corporations both international and domestic. Making investments in a variety of types of bonds is the best way to increase your portfolio’s diversity and better protect your investments.
What is the bond’s maturity?
A bond’s maturity is of primary concern for the investor. It’s the amount of time before the bond must be repaid. Lengths of maturities vary widely, between long-term (10 years or more), mid-term (3-10 years), and short-term (3 years or less). The length of a bond’s maturity should fall in line with the investor’s time horizons.
A Word on Diversification
In portfolio construction, diversification is key. Portfolio diversification means dividing your investments into multiple asset classes. Further, it means making sure your investments in each asset class are spread amongst a variety of subclasses and industries.
Why is this important? Typically, different asset classes perform well at different times. The idea behind diversifying a portfolio is that if one of the securities you are invested in is performing poorly, the others will keep you from suffering too greatly. Its main function is to protect your assets. Instead of a method for boosting returns, it’s a means of keeping your investments safe.
Mutual funds are one way to boost a portfolio’s diversification. On average they are made up of hundreds of securities and are available across a wide array of asset classes. Another option for diversifying your portfolio is to invest in multi-asset funds, an investment that groups multiple asset classes together.
3. Reassessment
Ongoing portfolio management is crucial to the long-term success of your financial portfolio. Part of this is recognizing when it’s time to reexamine your investment portfolio. There are a variety of forces that can signal the need for an update to a portfolio.
Life’s only constant is change. Your financial situation, future needs and even risk tolerance are all subject to change. It’s highly likely that at least one of these things will change over the course of your investing life, and your portfolio should be able to accommodate. Common life occurrences that can affect these changes are marriage, the birth of a child, and approaching retirement. In all three of these scenarios, a good wealth management advisor will be able to adjust for the new goals and priorities you have.
But changes in your personal life aren’t the only things that can spark the need for a portfolio adjustment, of course. Market fluctuations and a changing interest-rate environment can change the optimum asset allocation for your portfolio. This is where the experts can help. Keeping an eye on market movements requires attention and in-depth knowledge.
Does your investment strategy have enough diversity?
By monitoring the progress of your investments, you can learn if your portfolio is diversified enough. If your investments seem chained to the stock market and are affected heavily by stocks’ performances, you may need to re-allocate some assets.
How are your investments performing?
If this question is difficult to answer, it’s probably a sign that your portfolio needs a check-up. A good wealth manager will keep you up-to-date with the important aspects of your investments and make sure they understand your goals and how they change over time.
Saddock Helps You Build a Portfolio You Can Be Proud Of
At Saddock Wealth, we don’t have clients, we have partners in wealth management. Schedule a meeting with us here to discuss your goals and how we can help you preserve and grow your wealth.