Investment ideas are more abundant than the cottonwood fluff blowing around the Puget Sound area this time of year.
Media from CNBC to Barron’s or Money magazine offer “insight” on investments to sweeten your returns. Expand your search for the next big thing to the profusion of web sites, Twitter and the guy who lockers next to you at the gym and you end up with a paradox of choice, too many ideas to choose from.
Act on these ideas and you’ll wind up with a collection of investments but not a well-constructed portfolio. You’ll have individual pieces of a puzzle that don’t fit together into a coherent picture representing your financial preferences and life objectives.
While constructing a portfolio might be a more boring interaction with your money than trying to find underpriced investments that aren’t widely known, a purpose-built investment strategy is likely to be more lucrative to you over time.
Portfolio construction is a mix of art and science. Understanding your goals, your time horizon for those goals and your psychological comfort with a range of potential outcomes requires an artful understanding of the intersection of money and life.
Defining a risk/return profile that fits the artful understanding is more of a science — or at least an exercise in statistical probabilities.
Regardless of your money personality — go-for-it risk-taker or protect my principal at all costs — the best portfolio for you is the one you can stick with over time. Once you decide to become more aggressive or more conservative based on what is happening in investment markets, you’ve entered a performance chase and market-timing exercise that is nearly certain to leave you with a less satisfying experience.
To improve your chances of a satisfying outcome, you must first have a broader sense of your financial situation and the trajectory you are on to achieve financial security. This is more important than just focusing on finding investments you think could perform well.
When you begin with the bigger picture in mind, you can shift your mindset to the collective whole of your investment strategy, not the individual piece. This is where you start portfolio construction, thinking first about the risk/return profile you are comfortable with and how it translates to your weight of stocks vs. bonds — growth assets vs. defensive, risk-protection assets.
Traditionally, a neutral investor, not particularly aggressive or conservative, would have an investment mix of roughly 60 percent stocks and 40 percent bonds and cash. The weighting of stocks vs. bonds will have more to do with your overall returns than the underlying selection of specific investments.
It’s like completing the frame of the puzzle first. It gives you the foundation to move to the less obvious internal pieces.
Those internal pieces are where you can define the ratio of U.S. to international stocks, large companies compared to small company stocks, corporate vs. government or mortgage bonds, the mix of assets that provides diversification.
Next is an overlooked step to decide where to find certain types of investments for optimal tax efficiency.
You can spend your money only in the after-tax world. It’s your return after taxes, inflation and fees that is most important.
Bonds and other income producing investments such as real estate investment trusts or high-dividend stocks are best held in tax-deferred accounts that will be taxed at ordinary income rates upon withdrawal. This means employer retirement plans or IRAs.
Growth-oriented, low-income stocks and municipal bonds are better held in non-retirement accounts where capital gains taxes apply at lower rates than ordinary income taxes for most people. If you are eligible for a Roth IRA, this is where to place your holdings with the highest expected return to maximize tax-free growth. Emerging markets stocks and small-cap stocks fit here in a well-constructed portfolio.
Following this guide, we’re a few steps in before we even think about which individual investments to fill spots in the portfolio.
The foundational layer of any portfolio should utilize index funds that provide the broadest coverage of the global marketplace at the lowest cost. These funds would provide ownership of 14,000 global stocks and even more bonds because you can’t predict where the next market leadership will come from.
For those who prefer ultimate simplicity, this could be the entire portfolio. I prefer one-third to one-half of the total value of the portfolio.
At the core of the portfolio, rigorous academic scrutiny has demonstrated areas of the stock market that have historically produced higher returns. Tilting the portfolio (in a diversified way, not with individual stock picking) toward this evidence would emphasize small companies, value-oriented companies trading at perceived discounts, highly profitable companies and stocks that have strong price momentum.
With the remaining allocation — perhaps 10 to 15 percent of the portfolio — it can be helpful to use active mutual fund managers with specific skills or flexibility. This is particularly true for bonds. The bond market is not as transparent as the stock market. Utilizing a bond fund manager who has flexibility to go anywhere rather than being constrained to invest in a specific type of bonds can be valuable, particularly now that bond returns are challenged by rising interest rates.
Remember you likely don’t need to beat the market to achieve your financial and life goals. Many people, simply needing to achieve the market returns to “win” the investment game, underperform and reduce their financial security.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor. Reach him at gary@bhjadvisors.com.
