Five Key Steps in Designing a Portfolio

We thought it would be good to look at some portfolio management parameters. We will cover five issues involved in designing a long term portfolio. These steps apply to investing but could be equally applied to trading.

1) Risk Tolerance, 2) Time Horizon, 3) Liquidity, 4) Income Tax consequences, 5) Diversification. This is the foundation for creating a personal investment policy.

Risk Tolerance - Most investors confuse risk and loss as being the same thing. They are not. The most common phrase I hear in talking with investors is “make me 15% but don't lose any of my principal.” The formula to this would make me a rich man. What is the issue here? We want all the upside with no downside risk. The challenge in defining risk is more a psychological one than logical one. Thus, as investors we have to play what if? If you had $100,000 today and it was Jan 2000, you invest your money and Jan 2003 you look at your portfolio to see your balance is $60,000 what do you do? This is a buy and hold strategy which would make most investors run for the door. But, what if you invest your money in January 2000 with a defined strategy for maximum loss, profit targets, defined entry process and all this tied to your financial objectives? Regardless of your risk tolerance, you would manage your money not your emotions. Too much of financial planning today revolves around managing the investor's emotions versus managing their money. I will be the first to admit that I am a long term investor with well defined goals. But, I am also a human being who watches the markets and when my money goes down in value gets emotional about the losses in my portfolio. The key to risk management is not managing my emotions; it is in managing my money. And in so doing I indirectly manage my emotions. This is the most important key in investing. Learning the difference between risk and volatility as well as performance versus money management.
 
Time Horizon - When do you want to achieve the goal of the investment? 1 day, 6 months, 5 years. Defining the time frame will make the determination if your goal is realistic. Without a realistic time frame it will make managing the money frustrating and result in quitting. A defined goal keeps you from giving back what you have earned. Once the goal has been achieved you liquidate the investment in order to have the goal. That could be a new car, education for your children, a trip around the world, whatever the objective--it has been achieved. This keeps you from giving up gains for the bigger returns. Time goes hand in hand with risk tolerance and is an important part in determining your portfolio for the long term. Generally higher exposure to equities dictates a longer time horizon. Longer time frames also bring into play purchasing power risk versus volatility risk. Risk of inflation versus volatility risks have to be considered with longer time horizons. Time actually dampens volatility. A commonly asked question is, "what should I do with this $100,000 over the next six months while I wait to...?"  This shorter time frame brings volatility risk into play. The last thing you want is to be invested in equities and the markets move down when you need to take the money out. Thus, time horizon comes into play when selecting the investment to best suit the goal.
 
Another approach when determining time horizons is to break the goal down into increments to match your money management style. You don't have to change how you manage your money to meet a long term goal. Simply break the goal down into the timeframes that meet what you are doing with investments. Example: You have a 10 year old daughter and you want to accumulate $50,000 for her college education. If we start with $20,000 accumulated towards the goal we would need to make approximately 12% per year to attain the goal. If you invest with a time horizon of 3 - 18 months on average, then you should not change how you invest but break your goal down into simple increments of 3 - 18 month periods. This allows you to stay on pace to meet the goal as well as meet your style of investing. The key to investing is matching your money management style to the investment and the investment to the goal. The importance of having checks and balances in place is what gets you to the goal. Make sure you know the goal and time horizon to accomplish the goal. Then break the goal down into measurable benchmarks which meet your style of investing and to make sure you are on pace to accomplish the objective. I would rather know 6 months into a 10 year goal that I need to make changes rather than 6 months before the 10 years is up that I will not accomplish the goal. You can always adjust your risk tolerance and time frames but having to adjust them is what creates problems with investing.
 
Liquidity - Understand the asset you are trading or investing in when it comes to liquidity. Liquidity allows you the ability to convert assets into cash without a significant loss of principal. This is an issue most people don't take into account when gathering assets. Liquidity is a trading issue but it is also a lifestyle issue. When it comes to trading and investing liquidity means can you buy, sell or exchange the asset easily in the marketplace? An example would be a thinly traded stock. What if you need to sell in order to raise cash or because the market turns against you? You could take a significant loss or discount due to the lack of liquidity. Some ETF's (Exchange Traded Funds) currently trade with little liquidity and as an investor you should be aware of this before investing. Know what could happen if you have to sell. The same is true for buying. Thinly traded positions can cost more to own because of wider spreads when buying. When it comes to lifestyle, liquidity is one of the biggest mistakes investors make. Sometimes because we are so anxious to avoid taxes we lock our money up in tax-deferred investments such as 401k's, IRA's, Roth IRA's, Annuities, etc. When you need to access your money, you could experience penalties from the IRS and then the taxes to go with it. Example: you need to take $30,000 from your IRA and you are not 59½. There is a 10% penalty for early withdrawal and the taxes are due. Make sure you take into account these parameters prior to investing your money in these accounts. If you place all your money into tax deferred vehicles how will you live the lifestyle you want? Consider at younger ages you may want to own a larger house, save or provide for college education, new cars, or investment opportunities such as real estate. Tying all of your money up keeps you from living the lifestyle you want. Even in retirement individuals are discovering they deferred money at a lower tax bracket to pay more taxes in retirement. If you have $1 million in an IRA and withdraw 10% per year, or $100,000, you get to pay more taxes on the money now than you saved when you deferred the income from your $50,000 salary. I have heard people say they will be in a lower tax bracket when they retire. The only way to do that is earn less money. Who wants to retire on less money? The whole idea of accumulating money is to have lifestyle--not more money. Think about liquidity before investing.

Tax Consequences - Almost every investment decision comes with tax consequences. The first rule here about investing is to make sure what you are investing money into regardless of tax consequences will accomplish the financial goal. Even more importantly is that the investment will give you your money back in the future. Limited partnerships in real estate in the 80's had great tax benefits but few returned money to investors. You don't want to generate tax write offs by losing your principal. As you accumulate wealth the number one thing you will start to hate is taxes. We hear all the time from investors about the fact they made 20% on a particular investment in 6 months and then had to pay 30+ percent to the IRS. Yes they are your silent partner. But, as my father told me, you only pay taxes if you make money. That is true but it doesn't make us feel any better about it. Entire professions have been built for avoiding and paying taxes. Your goal as an investor is to make money to live the lifestyle you want. Therefore, choose your investment vehicles wisely. Tax favored investing is a good thing and something to consider while accumulating money. Tax deferred investments such as 401k's, IRA's, municipal bonds, and annuities all offer benefits and should be considered based on your goals and objectives--not solely for the tax benefits. Remember it is the end objective that will determine the best vehicle for use in travel to your destination. Take the time to evaluate by looking at what happens when you get to the end, as well as what you get today.

Diversification – The challenge in today’s marketplace is the justification of the old methodology of diversification. This is often referred to as a balanced portfolio. The philosophy is simply to have money in all the asset classes in order to balance market risk. The theory simply says having all your money in one asset class such as equities (stocks) increases the risk of the portfolios based on time duration. The primary asset classes generally used in diversifying a portfolio are, stocks, bonds, cash, real estate, precious metals, international, and miscellaneous other groups. In building a long term portfolio the use of all these asset classes come into play. The percentage of allocation to these sectors will depend on the current market cycle as well as risk and time horizon which we have already discussed. Too often investors lock in on one asset class and remain stuck there until something negative happens to their portfolios. An example of this would be the stock market correction in 2000. Many investors had their money heavily invested in stocks and until the pain outweighed the potential gain they held on. Diversification among the various asset classes would have helped avoid some of the downtrend in that sector of the market.

Not only is diversification important in building long term portfolios but time horizon brings another element into play. Planning for the capital accumulation phase and distribution phase of a portfolio is equally important. In this generation, we have on average 4-50 years to accumulate assets prior to retirement, and 30-40 years of retirement. This simply means we must plan for both phases of a portfolio and the diversification of the assets will depend on which phase your money is in. This brings risk tolerance back into the planning of diversification as well. As you can see all five elements of planning a long term investment portfolio intertwine into each other. No one area of planning ignores the other. To take this one step further the need for tax planning or tax diversification also comes into play. As we discussed in the earlier session on tax consequences, we need to plan for the ultimate taxation of money and diversify the options we have between pre-tax, tax-deferred, and tax-free.

The objective of diversifying your portfolio is not a one time thing, but something which should be reviewed and adjusted on a regular basis. The timeframe for this review is driven by the timeframe you have as an investor. The shorter the timeframe the more often you should review your portfolio. This is also true for the tax diversification portion of your portfolio design. A volatile marketplace is creating the need for more reality checks in portfolio diversification and design. It is more important than ever before to understand the risks and rewards in portfolio design.