Updated Wednesday, July 30, 2014 as of 7:15 AM ET
Portfolio Construction Is Boring, But Advisors Need to Read This Anyway
Friday, May 2, 2014
Print
Email
Reprints

Whatís changed over the past year in constructing the right portfolio for our clients? Absolutely nothing.

Sure, one could define the fact that stocks have surged and bonds have stayed basically flat as change, but thatís backwards looking.

Since nobody knows how markets (neither stocks nor bonds) will perform going forward, proper portfolio construction should be done to manage risk, not based on forecasting future returns. Here are the keys to portfolio construction, this year and next.

First, control risk. Have the right amount of risky assets (stocks) and low risk assets (high quality bonds) for the client. This is determined by the clientís willingness and need to take risk. If the client has met their goals, they likely should have a conservative portfolio. Itís great to have asset classes with low correlations (alternatives), but remember they must also have positive expected returns.

Second, control costs. Yes, costs and returns are inversely correlated each and every year. Owning the lowest cost and broadest index funds both reduces volatility and increases expected returns.

Third, control taxes. Once an asset allocation has been selected, we must then select both the products and the asset location. Again, the broadest stock index funds are the most tax-efficient as active funds pass through short- and long-term capital gains to our clients. This is even more important with the new 3.8% passive income tax on income over $250,000.

Next, asset location is key. Tax-efficient stock index funds are best located in taxable accounts and tax-inefficient assets such as bonds, CDs and REITs, are best located in tax-deferred accounts such as IRAs and 401Ks.

Fourth, control emotions. If the client panicked and sold when the real estate bubble popped, they could easily do it again. The client must be willing to stick to the asset allocation, meaning they need to be okay with selling stocks to rebalance after a great 2013, as well as buying fixed income, in spite of all the bond bubble predictions.

Though simple, these rules are anything but easy.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.

Read more:

Comment
Be the first to comment on this post using the section below.
Post a Comment
You must be registered to post a comment.
Not Registered?
You must be registered to post a comment. Click here to register.
Already registered? Log in here
Please note you must now log in with your email address and password.
Lists
2014 Summer Reading List for Advisors

Current Issue

The June Issue is now online!


TWITTER
FACEBOOK
LINKEDIN

Industry Events

August 10, 2014 |

September 9, 2014 |

September 17, 2014 |

September 20, 2014 |

September 28, 2014 |

Already a subscriber? Log in here