A Risk-Controlled Approach to Portfolio Construction

On a daily basis, the talking heads want us to believe they have all the answers to portfolio construction or portfolio management.

They prattle on that “The Dow is up 100 points, now’s the time to get in.” “The Dow is down 250 points, now’s the time to get out.”

Frankly, you should view these with a critical eye.

It’s not that professional money managers don’t care about what the Dow Jones Industrial Average (DJIA) does or doesn’t do. It is that a more relevant benchmark of the U.S. Stock market is the Standard & Poor’s 500 (S&P 500). It has always amazed me that the DJIA, with 30 stocks, gets more headlines than the S&P 500 which represents the top 500 stocks in the U.S. Even more astounding is that the S&P 500 represents only 15% of the total U.S. stock market, and the U.S. stock market represents less than 35% of all stocks traded around the world.

Why is the S&P 500 used as the almighty benchmark for investments? Who says that’s the way it’s supposed be? Just to complete the misrepresentation that the talking heads babble on about, they completely ignore the bond market. They want us to believe there are only two commodities of any note—oil and gold. What the talking heads seem to ignore most is the investment market that matters for constructing and managing a balanced portfolio for individuals, couples and families.

A professional money manager will look past the Dow, as well as the S&P 500, and craft a risk-controlled strategy that takes into consideration the long-term horizon and does not tempt the “fates of the gods.” This is accomplished by balancing risk with reward. Returns cannot be controlled or predicted.  However, risk can be controlled and measured. (For related reading, see: The Best Portfolio Balance.)

Factors to Consider When Building an Investment Portfolio

Constructing a well-thought-out portfolio is going to take into consideration several factors.

  • First, what is the financial condition of the investor?
  • Does the investor have an adequate emergency reserve fund to cover the "OMG" moments of life?
  • Is there adequate insurance in place to take care of the inevitable catastrophic events of life?
  • How much investing experience does the investor have?
  • What is the employment picture?
  • How about health issues?
  • When will this money be needed and for what reason?
  • Does the investor trust professionals to take care of his or her money?
  • How does the investor react to the “news de jour?”

Once these questions have been answered, then a professional advisor will construct a custom personalized target portfolio.  Start by selecting a mix of:

From here we break the mix down into several more refined investment objectives to diversify the investor within the category.

Testing the Portfolio Mix

The next step is to back test the mix. Historically we want to look back a minimum of 15 years, 20+ is optimal. Why go to this extent? The reason is we do not know what the future holds. So, by looking backwards over a long period we can measure how a portfolio responds to good times and bad. Over a long period, we can get a good sense of the risk and return that we might expect over the next 15-20 years. 

What we want to accomplish is to balance the risk we take with our money with the returns we might expect. The goal is to have lower risk than the U.S. stock market, but achieve similar returns over a long cycle of time. Once the investor can grasp that concept, then the talking heads are no longer relevant. (For related reading, see: Measure Your Portfolio's Performance.)

Perhaps a helpful analogy might be a philharmonic orchestra. There are many different types of instruments. Separately they might sound ok, but combined with the direction from a maestro, they make fantastic music that will thrill your senses.

Keeping Balance in a Portfolio

Once we have selected the best mix, our next step is to keep it in balance. As investments change over time, we want to stay disciplined to our target. This avoids the temptation of testing the “fates of the gods.” Nobody stays on top for ever, and past performance is no guarantee of future results.

Staying true to the target, we will periodically go in and rebalance the portfolio so our objective stays consistent with the goal. Experience teaches us once you have a well-crafted target and you keep it balanced, then the best friend an investor has is patience. The emotions of investors are very often the reason for sub-optimal returns. We tend to be our own worst enemies.

(For more from this author, see: How the Fiduciary Standard Affects Your Investments.)

 

The information provided is solely for informational purposes and  is not meant to be, and should not be construed as advice or use for investment or Financial Planning purposes. It is recommended that before making any decisions regarding Financial Planning or Investment Advice that you seek the counsel of a Trained & Certified Fee Only Professional.