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There are many different approaches advisors utilize when managing money for clients. Some adopt a passive strategy buying only the indexes while others pursue alpha through active management. Some believe still in buy and hold while others favor market timing. There is also the decision of what types of investments to buy, e.g., individual issues or packaged products. These are only a few of the questions an advisor faces. One thing is clear: the recent and precipitous decline in the financial markets has been a catalyst for concern as many advisors question their previously held philosophies on investing.

As part of my ongoing efforts to help advisors new to the profession or new to the independent model to find their footings, I’d like to share my thoughts on these and other very important issues that we, as advisors, routinely face. For more experienced advisors, these thoughts may provide some practical help as well. I recognize there are many different methods for managing money so I hold no illusions that I have discovered the Holy Grail of investing. What I can say is that the process I’ve adopted has held up relatively well during the recent collapse and works well for me and my clients.

In my business, I have broken the investment process down into eight distinct steps, which we will explore now.

Step One: Determine the Required Rate of Return

As Yogi Berra once quipped, “If you don’t know where you are going, you will wind up somewhere else.” If you don’t know what rate of return you are targeting, how will you know if the portfolio you have designed is appropriate? Determining the required rate of return is one of the most crucial steps you can take. The method I use to do this is a financial plan. First I create the plan. Then, I stress test it by reducing the returns assumption to the point where the results of a Monte Carlo simulation begin to show the assets expiring prematurely, i.e., whatever the return is when the probability of running out of money begins to emerge; that becomes the lower bound of the required return. I will then add 50 bps to that number to create a range.

Step Two: Determine the Risk Tolerance

After determining the required rate of return, the focus turns to the subject of risk. Specifically, how much risk must we assume in order to reach our required return?

Assessing a client’s willingness to assume risk is critical. Today, there are several risk questionnaires in circulation and I have personally read a number of them. While some require only basic information, others include questions in the arena of behavioral finance. Whichever risk questionnaire you prefer, it should provide you with a good understanding of the point at which your client would become uncomfortable with the portfolio.

It’s important to note that human emotions change over time, based on a number of factors. Some are internal while others are more environmental. The truth is, however, that most of us are irrational beings. Since the research shows that our decision making is largely emotional, if the risk profile excludes behavioral finance questions, then I suggest its value is limited. Therefore, restricting the questions to time horizon and risk tolerance may be expedient, but it will likely fall short of its intended goal. I have also found that clients will overstate their willingness to assume risk in bull markets as greed kicks in and understate it when times are bad as they become fearful.

There’s another important point to make here. Don’t get in a hurry just to get to the final score that the questionnaire yields. Often the conversation goes something like this: “Okay, Mr. Client. You scored a 35 and that makes you a moderate-to-aggressive investor. I recommend portfolio number four.”

You should ask questions beyond this superficial level to determine if portfolio number four is, in fact, appropriate. Instead, I recommend asking, “What if your $1 million portfolio fell in value to $700,000. How would that make you feel?” In many cases the answer will be, “Not so good!” If so, then continue moving to a more conservative portfolio until you find agreement. Especially in light of more recent experience, focus on how clients might react in a bear market.

Step Three: Determine the Broad Allocation

I spent my early years with a large wirehouse firm where we were taught to invest in stocks, bonds, and cash. That was it! There wasn’t much discussion about alternative investments, at least not within the company. I also recall that an aggressive portfolio was 85% in stocks and a moderate to aggressive portfolio had 70% in stocks. Obviously that worked during the bull markets of the 1980s and ’90s, but if you were holding that much in stocks when the recent bear came knocking, your portfolio got mauled. Moreover, if you lost 50% in a year, you would need to earn 100% just to break even. Therefore, in my view, managing the downside risk is the single most important thing you can do for your client’s portfolio and this is where it begins.

Now that the required return and the client’s willingness to assume risk are known, what mix of assets will provide for a high probability of achieving the objective and how do you determine it? Some advisors rely on mean-variance optimization. Let’s discuss this for a minute.

The goal of optimization is to find the portfolio which offers the highest expected return for a given amount of risk or the least amount of risk for a given level of return. While this goal is admirable, is it realistic? To create an optimization you must assume three things, possibly four. The three primary assumptions are return, risk, and correlation. Let’s look at return assumptions. Do past returns offer any insight into the future? According to William Sharpe, past stock returns possess no predictive value. If this is true, then your return assumptions must be forward looking and I’ve never known of anyone who could accurately predict stock market performance with any consistency.

What about risk? Past risk does provide some insight into the future and is useful. The third assumption is the correlation between asset classes, which does vary over time. While those are the inputs necessary to create an efficient frontier, there is another issue, tracking error. Even if you are spot on with the first three assumptions, what if the holdings you select do not track well with your categories? Moreover, I would ask whether they should. While I don’t want my large-cap value manager looking for small growth companies, I do want them to have some flexibility in stock selection. Besides, if they track very closely with their index, why not just buy the index?

At first blush, optimization is pretty exciting. Yet while it may sizzle with excitement, it can also yield some pretty bizarre results. For instance, without placing constraints on the categories, the recommendation may be to invest 60% in small-cap stocks, 30% in cash, and 10% in real estate. What if optimization were applied to the human diet? We might be eating 70% bulgur wheat and 30% broccoli. How many of you would enjoy a steady diet of that? To avoid this type of result, you must place constraints on the categories by assigning a minimum and a maximum percentage for each. If you place constraints on the categories, however, aren’t you defeating the whole purpose of optimization?

Therefore, in portfolio construction I search for assets with a good risk/return relationship and a low correlation to the broader stock market. I also spend a lot of time reading and watching the financial media for insights. In addition, I spent a considerable amount of time creating and testing portfolios to see how they performed during bear markets. My ultimate goal is to find the combination of assets that protects well on the downside and let the upside take care of itself.

My focus is on managing the risk in the portfolio and alternative investments can help. Today, I place as much as 25% to 30% of a portfolio into this category (see below for what I categorize as “alternative”).

Step Four: Create an Investment Policy Statement

I use a Microsoft Word document to create the IPS. Basically this document includes the expected return, allocation guidelines, cash flow needs, tax concerns, and other relevant information which may influence how I manage the portfolio. Circumstances may dictate a change of plan, such as during the past 18 months.

Step Five: Select the Subcategories

After you determine the broad allocation, you must choose the subcategories. Early on I was taught to diversify over a number of categories. I have since learned that all categories are not created equal. Some categories offer a better risk/reward than others. Time doesn’t permit me to go into much detail here, but here’s is a brief look at some the subcategories I use.

Stocks. I favor large cap over small, domestic over foreign, and value over growth. In fact, I really don’t buy growth funds since value stocks have outperformed growth stocks over time and with less risk (See Value Versus Growth sidebar). Besides, most value managers hold some growth stocks in their portfolio anyway.

Bonds. For bonds I invest in mortgage-backed, traditional intermediate-term corporate bonds, and TIPS. My goal here is to achieve a positive return with the bonds no matter how interest rates are trending. As long as rates aren’t moving aggressively to the upside, this has worked well. In addition, depending on the portfolio, I will add short-term and ultra-short-term bonds for added stability and round it off with convertible bonds.

Alternative Investments. Although real estate could easily be included in the stock category, I use it here. I also use a hedge fund of funds, currency ETFs, commodity funds and ETFs, and long-short or market neutral funds. As I mentioned before, I am seeking assets that are not highly correlated with the broader stock market.

Step Six: Select the Specific Holdings

In selecting the specific holdings, I use two primary tools. The first is Morningstar’s Office Edition, which includes a robust research tool, and the second is a proprietary Fiduciary Scorecard I developed for mutual funds and ETFs. In Office Edition I have established specific screens for each subcategory. Once every quarter I review the screens and compare the results to the funds I use. Then I use the fiduciary scorecard to narrow my search.

Drawing from global fiduciary standards, my fiduciary scorecard incorporates data for multiple time periods into five distinct areas, and then compares each fund with their specific peer group. The five areas in the scorecard are risk, expenses, relative performance, management, and consistency. Each fund receives a score from 1% (lowest) to 100% (highest). If a fund has a low score, I look for the reason. Depending on what I find, I will either sell or maintain the holding. In some cases I will call the fund to get an explanation. I review the scorecard monthly (See my Road to Independence blog at for more on the Scorecard).

Step Seven: Implement the Portfolio

In my opinion, deciding whether to invest all at once or over time is one of the most difficult decisions to make on behalf of a client. The answer depends on which category you are talking about. The more risky the category, the more caution is required.

So in stocks, for instance, if you jump into the market with both feet you will lose more if the market turns south. For the past 12-18 months I have favored getting in a little at a time, keeping a good deal of cash on the sidelines. For the fixed income and alternative portions of portfolios, the math is different. If you invest all at once in bonds, your downside is limited. Therefore, I am much more comfortable doing this with the bond portion of the portfolio and possibly some of the alternatives. With alternative investments, especially the more tactical portion (i.e.; currency and oil), my decision depends on the economic outlook.

In the end, however, your answer to the process of implementing the portfolio should depend in part on your outlook for the economy and the markets. For instance, I believe we’ve been in a secular bear market since the tech bubble burst. I also believe government spending will reach new heights as additional programs are added. Our larger, more bloated government will also require higher taxes and higher taxes could create a serious headwind to economic growth as it takes money out of the hands of the consumer and the wealth creating entrepreneur. We are adding a massive amount of additional debt and the responsibility to repay will become a burden to future generations. This indulgent spending could possibly hurt our credit standing in the world community and drive interest rates higher. As we monetize the debt, it could devalue our currency and increase inflation.

If all of the above materializes, then I would favor foreign investments, commodities, and TIPS. So I suppose my answer to the question of investing all at once or over a period of time is, “It depends.”

Step Eight: Monitor the Portfolio

When monitoring the portfolio I examine the broad allocation as well as the underlying holdings. Although I conduct client reviews quarterly, I evaluate each account much more frequently. Currently, I am holding a fair amount of cash so I can take advantage of investing opportunities as they arise. The bottom line to me is the advisor’s version of the Hippocratic oath, “First, do the client’s portfolio no harm.”

As mentioned, there are many different methods for managing money. With the regulatory climate in Washington, it’s likely that advisors will be under closer scrutiny in the future. Because of this, the time to reevaluate our approach is upon us now. I hope reading about my approach will be helpful to you as you fine-tune your own.


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