Five Keys to Great Portfolio Construction

What are the keys to great portfolio construction? I believe despite the following list, there are still ways to construct a portfolio that will outperform:

-Fear of the FED raising rates?
-Fear of the Chinese economy entering recession?
-Fear of the price of oil dropping so far it tanks the economy?
-Fear that the strong dollar slows down US GDP?

My thoughts are that the “FEAR” of (fill in the blank) can be overcome with proper portfolio construction. Here’s a step-by-step process to accomplish just that.

1. Formulate a return objective. I have written about creating an Investment Policy Statement (IPS) in previous writings and this is where the concept originates from. Everything starts with a return objective in goal-based planning. Simply put, how much do you want to make? An accompanying “why” you require this level of return helps, but is not necessary. Let’s start with this following:

Investable assets: $1,000,000
Annual after-tax income needed: $70,000
Tax Rate: 25%

Therefore, $70,000/$1,000,000 = 7% (after-tax) or,

7%/ (1-.25) = 9.333% (before-tax)

Therefore, 9.33% is the annual rate of return (before taxes) you would need to earn in order to achieve your return objective.

2. Assess risk tolerance. Risk assessments can come in all types of shapes and sizes, but the two important things are measuring both your ability to assume risk and your willingness to take risk. The former is more of a quantitative assessment and will take into account your net worth, income and those kind of factors. The latter is more of a qualitative assessment and has to do with your behavior and how your mind thinks about risk. Usually, a risk tolerance questionnaire is used to assess a person’s willingness to take risk. Here is a link to one that is really good (in my opinion!)

2. Set investment constraints. (Bear with me, we will get to the fun stuff!) Constraints are also very important because they set boundaries around your investment process. Many investors find themselves uncomfortable with portfolio investment choices well after they are made because this step is often missed or not even discussed. Will there be tax considerations to take into account? How much liquidity should the portfolio maintain? How long is the time horizon? Is this a single or multi-stage investment plan? Should the investments be socially responsible? Will there be a wealth transfer that involves gifting to heirs? As you can see the questions can go on and on as well as be complex. These should be explored with a qualified professional.

3. Create an asset allocation. Here is the part that most plans “skip” straight to. Now of course, the plan must include assets, but what mix is appropriate? Well luckily by now you have taken the time to go through the previous three steps making this process much less elusive. Let’s see what data we’ve collected so far:

Investable assets: $1,000,000
Annual after-tax income needed: $70,000
Tax Rate: 25%
Required return: 9.333%
Risk Tolerance: High
Current Age: 35
Time Horizon 25 years until retirement, then 30 years until death

From here, we can narrow down the asset classes we should choose from. For example, we know with such a long time horizon (25 years) this investor should have a large portion of “equity-like” (i.e. stocks) in the portfolio for growth. Also, from the risk assessment we see that equities as an asset class are appropriate. We could even diversify further between domestic, international and emerging equities. Next, we see that the tax bracket of 25%, would make municipal bonds more appropriate than government bonds and maybe even corporate bonds depending on the rates of return. However, we already know that bonds as an asset class will comprise a lesser portion of the portfolio due to the relatively high rate of return needed (9.33% per year).

5. Create a system to monitor results. Set it and forget it has rarely worked as a strategy. Portfolio winners must be eventually sold off as they will begin to become a bigger percentage of the overall portfolio. Losers may need to be sold in tax loss harvesting strategies or if they are just weak performers. The trimming of each, represent necessary portfolio rebalancing at regular intervals. The frequency of the intervals will most likely be a function of transaction costs.  Additionally, you will want to know how close you are coming to your return objective.  From the above example, approximately 0.78% must be earned each month to achieve the annual return objective of 9.33%.  This can be tracked by the monthly statements generated by your brokerage firm or investment advisor.

Invest wisely!

Author: The Maven of Financial Literacy

Dominique is owner of DJH Capital Management, LLC. a full service, comprehensive financial planning firm helping individuals build roadmaps to reach their financial dreams.