Deciding on the most fitting vehicles to implement a strategy is no easy task. The investments we want to own in the portfolio can conflict with the investments we need to own. Human nature creates bias, which leads us to desire investments that have recently performed well, potentially hindering us when the market turns. These biases can also create concentrations that can leave the portfolio woefully off-balance at times, potentially limiting its ability to deliver the return goals we seek.

Investing should be about the windshield—not the rearview mirror. Everything you choose should ultimately be valued by its ability to enhance your portfolio’s potential performance against its benchmark (which should represent your return and risk targets). If it doesn’t raise the level of expected risk-adjusted return—either by enhancing future returns or reducing risk—then it shouldn’t go in your portfolio.

Important questions to ask

When evaluating an investment, investors should ask: (1) How does it align with your overall investment strategy and objectives? (2) What could cause it to gain or lose value, and by how much? and (3) How does it work with the other holdings in your portfolio? Finally, if you decide to include it in the portfolio, (4) How much of it should you own?

Assessing the choices

The selections are vast. Individual stocks may offer terrific upside, and individual bonds can offer permanence and definition, but both security types also bring security-specific risk that can be undiversifiable in a portfolio, and thus, tough to recover from if anything goes wrong. Owning a stock that doubles in price is terrific to share at cocktail parties, but remember that if the stock can go up a lot, it also has the ability to fall a lot. Just ask anyone that owned internet stocks in 2001 or energy stocks in 2015. Big winners can be great to brag about, but big losers can wreak havoc on a portfolio.

Examining mutual funds extends beyond looking up rankings and reading analysts’ reports. Evaluating each fund’s track record is important. However, don’t simply screen for top performers, but rather understand each fund’s performance, and how it was created. How have both the fund and its benchmark performed in a variety of market environments, in terms of both risk and return? What types of markets does the fund do well in (both absolute and relative to its peers/benchmark), and when does it lag?

If you’re considering exchange-traded funds (ETFs), many factors play a role in selection, but cost is usually a big determinant. In addition to fees, you should also consider implicit costs, including your cost of trading, and the ETF’s own rebalancing costs. Whether you seek a targeted or broad market exposure, ensure the ETF you choose provides what you’re looking for, without introducing additional market factors. In addition, examine the ETF’s liquidity and structure. Is it truly an ETF, or is it really structured like a unit investment trust in an ETF wrapper? This can be an inefficient way to track the index you’re seeking to mirror. Is the ETF connected to an index mutual fund? This will potentially cause it to lose some of its tax efficiency. These issues are easily avoided with a little research.

Whether you’re after mutual funds or ETFs, one common question should be, “Is the manager who runs this product any good at it?” Answering this question involves evaluating the manager’s tools, experience, process, and history. Two products could have similar returns over a five-year period. One delivered an amazing return for one of those years, combined with four so-so years, while the other delivered four years of above average performance and one year that was a little below. Which of these two would you rather own in the future?

Asking the right due diligence questions

Researching and choosing from the ever-growing number of options can be time consuming and confusing. A disciplined investment selection process helps a portfolio to potentially capture the returns the market offers, while limiting the decisions that either unintentionally lever bets or reduce diversification—either of which can negatively impact its ability to generate the return goal.

When adding something new to your portfolio, two key thoughts to consider: (1) Does it offer something unique that the portfolio doesn’t currently have, or is it increasing the bet on something I already own? And (2) What do I plan to sell in order to buy it, and what happens when I remove that security from the portfolio? You don’t automatically become better diversified simply because your list of “best ideas” gets longer.

Working with a professional financial advisor can bring objectivity and expertise to the process. It can also bring peace of mind: Our BlackRock Investor Pulse research suggests that investors who work with a financial advisor feel more confident and better prepared for their financial future.

Selecting the right investments is a lot more than choosing what you think will go up the most in the future. It also involves owning a few things that you likely aren’t happy to own—this is where real diversification comes from. At BlackRock, in-depth knowledge on every investment being considered is gleaned by putting each through rigorous analysis. It’s critical to devote the necessary time to this step in the portfolio construction process, or find ways to outsource it to a party capable of conducting the necessary, ongoing research.

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.

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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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