Portfolio Construction

For investors who are just starting out (or starting over), the process of building a portfolio from scratch can be a daunting one. With literally tens of thousands of stocks, mutual funds, bonds, CDs, and other financial instruments to choose from, many investors don't even know where to start. Often, people end up choosing random assortments of various securities with no rhyme or reason and no discernable strategy—usually a recipe for failure. The following conversation provides a few general tips for portfolio construction.

Client: After years of working with a broker, I have decided to manage my assets on my own. Where should I start?

Adviser: When entering into any type of investment strategy, it's imperative that you do a thorough examination of your financial goals. Of course, it is always easier to get what you want when you know what you want in the first place.

Before assisting any of my clients in designing an appropriate portfolio, I spend a great deal of time learning about their investment objectives, time horizon for their assets, cash flow needs, tax considerations, restrictions, and other important factors.

Client: OK, I'm only 50 with no immediate income needs and a lengthy time horizon. All I want these assets to do is grow with market like-returns. What next?

Adviser: After clearly establishing your objectives, the next step in creating a portfolio is selecting an appropriate benchmark.

Client: What purpose does a benchmark serve?

Adviser: Let's assume that we choose an all-equity benchmark (and with your stated goals, this might make sense). A benchmark really serves two purposes for investors. First, a benchmark acts as a roadmap for your portfolio. Rather than merely selecting stocks at random, managing against a benchmark provides you with a framework for creating the strategy. Pretty simple, and a great way to keep you disciplined.

In addition to helping construct the portfolio, a benchmark also acts as a comparison point for your performance to measure opportunity cost. If you wanted to create a portfolio consisting of all U.S. equities, you might use the S&P 500 Index as a benchmark. Let's say your portfolio, once constructed, returns 10%. Not bad, right? Well, it depends on what the benchmark did. If the S&P 500 returned 5%, you had a great year. If, on the other hand, it returned 25%, you had a pretty poor year.

Client: So how do I know which benchmark is right for me?

Adviser: Knowing you desire long run stock market-like returns, an all-equity benchmark probably makes the most sense. Over very long time periods, most well-constructed equity indices will achieve similar returns, but they provide those returns with varying levels of volatility. That volatility is really a function of how broad that benchmark or index is. In my opinion, it's usually best to pick the broadest indexes available, because, over the long term, they will generally provide the smoothest ride. Some good examples might be the Morgan Stanley Capital International (MSCI) World Index (a global benchmark) or the S&P 500 Index (a US only one).

Client: OK, selecting a benchmark seems simple enough. How does that translate into actually selecting the securities within my account?

Adviser: Selecting a benchmark is the relatively straight forward part. Once you know what you're managing against, you can start having some fun. Each benchmark can be broken down into smaller parts – i.e., sectors (Energy, Utilities, etc.), countries (U.S., Japan, etc.), styles (value and growth), and size (small, mid and large capitalization stocks). Once you break the benchmark down, you have to think about the expected return of each component. In other words, over the next 6-12 months, how is Japan going to perform? What about small cap stocks?

After making forecasts for each component, you can decide how to allocate your portfolio towards those areas. Let's say you really like Technology stocks, which comprise 15% of your benchmark. You might decide to put 22% of your portfolio in Technology companies. If you didn't like the sector, you might do less than that.

Once you have done all this, stock picking becomes largely a function of the higher level decisions you've already made.

Client: OK, I like domestic Technology stocks. I think I'll put my entire portfolio in those securities.

Adviser: Hold on. Let's say you do allocate your portfolio completely to Technology stocks. If you're right, you stand to do very well, but what happens if Technology has a bad year? You're sunk.

When building a portfolio, risk control should always be in your mind. Have a core strategy – i.e. the areas of the market you expect to do well. Just as importantly though, you'll also need a counter strategy to diversify the portfolio and lessen total risk. Your portfolio may always have some stocks that underperform, but if you get your broader forecasts wrong, they provide ballast.

This is a very basic and simplified tutorial on the basics of portfolio construction. Less experienced investors may be better served delegating some or all of this responsibility to a trusted advisor.

-------------------------------------------------------------------------

The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.