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Portfolio > Portfolio Construction

Hitting for Average Rather Than Swinging for the Fences With 3-D Portfolio Modeling

By Mike Patton

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When you decide to become an independent advisor, there are numerous issues you must settle. For example, you have to decide which services you will offer and how you will price them. The real challenge is to find a way to separate yourself from every other advisor offering the same services. Most will offer portfolio management and some offer financial planning. Then there are those who offer both.

You may think you have a superior asset management skill, and perhaps you do possess some unique alpha-adding ideas, but in the end, it's the client who must understand and appreciate your value-added proposition. I've heard from both old and new practitioners who firmly believe that an advisor cannot add much in portfolio management beyond the indexes. There are others who believe they add significant value here. The point I'm trying to make is this: Whether you actually add value here or not, how do you communicate your uniqueness to the client in a way that makes them want to work with you?

Are you the type of advisor who swings for the fences looking for the next Apple or do you build portfolios to reduce risk through diversification? I tell clients that if they work with me, they shouldn't expect to hit a home run. I also tell them that I am the guy that will make sure their portfolio won't blow up!

A few months ago, I made a significant directional change to my asset management process. I must confess that I'm still tweaking it, but believe it is a superior method. Let's start with the subject of diversification.

First, stocks are the dominant part of the portfolio in terms of volatility. The greater their allocation, the greater the variance. Therefore, if your goal is to reduce risk, as the percentage of stocks increases so should other, non-correlated assets. Let's assume you use only stocks and bonds. There is an equilibrium point where the allocation to bonds would offset the volatility of the stocks. Let's say that allocation is 15% in stocks. With 85% in bonds, even if stocks took a tumble, the portfolio might remain positive on a month to month basis. Obviously, there are many other factors in this such as the degree to which stocks tumble, but let's look beyond that for a minute. Conceptually, I think this is a valid point. How do you measure this? Well, you could use Morningstar's Hypothetical tool, but this could be a time-consuming task. Therefore, I have subscribed to a rather amazing program from Gravity Investments.

This tool allows for a 3-D view of a portfolio and provides a quantitative measure of a portfolio's diversification. Proceed with caution, though, as the learning curve is a bit steep, especially, if you've been a nine-box asset allocation advisor for years.

Have a great week!

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