Last week, we introduced you to our weekly Investment Committee meetings. When we met for class on 4/27/18, we began our discussion on the subject of an “optimal portfolio.”
The centerpiece of investment management is portfolio construction. Alongside financial planning, the manner in which one’s money is invested is critical to meeting one’s financial goals.
Before attempting to construct the best portfolio possible, it is important to identify some core beliefs when it comes to investing. There are many, but a few we would like to highlight are:
- Markets are efficient: By and large, the best estimate of the true intrinsic value of a stock or bond is whatever price the security is currently trading at. Free lunches almost never exist, though in hindsight may seem obvious. No one really knows what will happen to the market tomorrow or the next day.
- Only take systematic risk: When you own the broad stock market, you are exposed to variability in the value of your investment (risk). When the economy is good, a diversified stock portfolio will go up, and when recessions hit, it will go down. The investor is rewarded for taking that risk. Over time markets go up, but the ride is bumpy. When one owns individual stocks, they are still exposed to that same economic risk. However, they are also exposed to company specific risk. The company specific risk associated with each individual stock averages together to get the broader market, meaning on it’s whole provides no additional return. By concentrating your investments into specific holdings, you are exposing yourself to increased risk without improving expected returns.
- Risk and return are highly correlated: As markets are efficient, and assuming only systematic risk is being taken, the more (less) risk you are taking the higher (lower) your return should be over long periods of time. Since 1926, U.S. stocks have averaged a 10% return. If you were told going forward you’d get 10% every year, everyone would sign up, driving the price up until the expected return was lower. The fact that the market can be up or down 40% in a year is what makes it risky and along with that comes a return.
Keeping these “truths” in mind, we construct an optimal portfolio with the goal of achieving the following things:
- Achieve the highest risk-adjusted return: Through the application of modern portfolio theory, we want every portfolio to deliver the largest return for a given level of risk. Financial advisors and investors together are responsible for determining how much risk the investor can and should take. At that point, we find the combinations of investments that deliver the highest expected return.
- Keep costs low: Research shows that paying too much in fees and commissions eats into returns. Keeping costs low and achieving market returns in the most efficient manner is the proven way to build wealth.
- Simple and customizable: Research has shown a few factors drive returns. Introducing a multitude of strategies and products generally complicates things, often driving costs up without improving returns. Additionally, every client is unique and an optimal portfolio must be customizable to their specific situation. Whether it’s a legacy stock position with large capital gains, or an employer sponsored retirement account with poor/limited investment choices, an optimal portfolio needs to be able to be customized. Simplicity meshes better with customization than complexity.
Having a plan and sticking with it is critical when it comes to investing. Cognitive and behavioral biases cause people to make emotional decisions which harm their financial well being. Understanding and buying into the investment management piece of one’s finances, helps the investor and the advisor stick to the plan and avoid the mistakes that harm most investors.