Baseball great Yogi Berra may have said it best: “If you don’t know where you’re going, you’ll probably end up somewhere else.” This pithy statement is true in most areas of life, and it certainly applies to effective management of your investment portfolio. Without a clearly conceived investment philosophy—an overriding rule or concept that guides your day-to-day investment decisions—you’re prone to fall victim to the traps and blind alleys that catch so many individual investors: emotional reaction to market movements; chasing the latest “hot” stock, fund, or concept; attempting to time the market; and others.
Instead, with a solid philosophy built on evidence-based investment principles, you can manage your portfolio with confidence and clarity, allowing the market to work for you instead of against you. By understanding and applying some basic, data-driven guidelines, you can take the guesswork out of investing and look forward to benefiting from the market’s expected returns over the long haul.
Your investment philosophy should be built on evidence-based best practices for portfolio management. Let’s take a look at some of the most important of these best practices that can set you on a path to reaching your most important financial goals.
1. Asset allocation
To capture expected market returns over the long haul, it is vital to construct a portfolio of assets that are positioned to benefit from the financial markets’ historically demonstrated long-term trends. But each investor is unique, with different goals, timelines, tolerance for risk, and values. So, it follows that there is no “one-size-fits-all” model for how much of a given investor’s portfolio should consist of equities, how much in fixed-income, how much in real estate, and so on. The first and most important step, then, is conducting a detailed examination of the investor’s needs, resources, attitude toward market risk, and position in the investing life cycle. For example, a young professional with decades before retirement might benefit from weighting her asset allocation toward more volatile assets with characteristics for long-term growth at a rate greater than inflation. On the other hand, an investor nearing or in retirement might choose assets with less volatility that generate a more predictable income stream. The point is, proper portfolio design should begin with strategic decisions about the types of assets to be included as well as the relative proportions of the portfolio that various asset types should comprise.
2. Diversification
Spreading risk among a variety of assets is perhaps an investor’s best tool for mitigating the effects of market volatility in the portfolio. This is the approach indicated by the well-known proverb, “Don’t put all your eggs in one basket.” Perhaps the most important aspect of proper diversification is including assets that are not correlated: that is, assets that are not affected by the same market forces at the same time. For example, some investors may think that by owning a mutual fund made up of 100 different large-capitalization stocks, they are diversified. However, because the same market factors tend to affect many large-capitalization companies in the same way, their risk is actually concentrated in a single sector; they are not effectively diversified. Conversely, a portfolio made up of mutual funds focused on different industry sectors and markets (small-capitalization, growth stocks, dividend-paying stocks, international equities, and fixed-income, for example) is more diversified, because it contains assets that respond in a less-correlated way to various market forces.
3. Tax efficiency
It matters not only how much you make; it also matters how much you keep. For that reason, effective investment management should include attention to minimizing the tax burden on investments. Tax-efficient portfolio management can include such strategies as a focus on holding appreciating securities longer in order to benefit from the lower tax rate applied to long-term capital gains; avoiding assets that are typified by frequent buying and selling activity (a feature of some actively managed funds), which may generate excessive short-term capital gains (taxed at a less favorable rate); tax-loss harvesting (recognizing losses in one part of the portfolio that can be used to offset gains in another part); or holding assets generating current income in tax-advantaged accounts like IRAs, 401(k)s, or 403(b)s. While the tax-efficiency “tail” should never wag the investment “dog,” attention to tax-efficient strategies can significantly enhance portfolio values over the long term.
4. Rebalancing
Inevitably, as market pricing causes the values of various portfolio components to change, the asset allocation percentages will be altered. Over time, this usually results in one or more portions of the asset allocation model getting out of the optimal proportions. When this happens, the portfolio should be rebalanced, by buying or selling various assets, to return the holdings to the proportions called for by the investment strategy. In fact, sometimes tax-loss harvesting, mentioned above, can function as a component of rebalancing activity, adding a tax-efficient benefit to the process. Astute investors understand that periodic rebalancing is needed to maintain adherence to the guiding investment philosophy.
There are other techniques and disciplines that could be included in a discussion of investment philosophy and portfolio management, but these four are foundational to most approaches. At The Planning Center, we work with clients to clarify goals, values, and priorities in order to establish durable, individualized guidelines for portfolio management. If you or someone you know could benefit from a better understanding of investments, let’s talk.
Review our webinar on best practices for investment management.
