There are several ways to construct a portfolio:
- Some build with a top-down approach, building the portfolio from a pre-decided overall allocation and filling in the needs for stocks, bonds, cash, etc.
- Some build from the bottom-up, choosing investments with the characteristics they prefer and forming an allocation based on how much exposure they want to each selection.
- Some build within the context of a financial plan, looking at income and risk need constraints to create a strategy, a mix of assets, to meet their goals. Some people rebalance based on that mix, but if we’re being honest, most do not.
No matter where you fall on the spectrum, it’s important to ask yourself questions along the way – portfolio management is not a spectator sport.
- Does your strategy align with your goals?
- Is your strategy working to achieve these goals?
- What progress have you made?
- What about the tactics being employed to implement the plan?
It’s important to check in with your strategy periodically to make sure it aligns with what you’re looking to accomplish. It’s also important to understand what roles and responsibilities you are taking on as the primary advisor for your own portfolio, and at what point you have delegated that responsibility.
If you’ve delegated the responsibility for day-to-day management to someone else, you will still have to maintain oversight and track their performance. Even if you are completely self-directed, you have delegated some responsibilities to a third party, even if you didn’t realize it.
Delegated? What do you mean? I manage my own investments!
If you own a mutual fund, ETF, unit trust, or even an individual stock, you might not realize that someone else is doing most of the work. Through these products, you have delegated the responsibility of selecting the composition of your portfolio to a fund manager in some capacity. You are now a manager of fund managers.
- Actively managed mutual funds and ETFS have fund managers who choose the investments in the fund.
- Index funds and ETFs have a committee to choose the stocks or bonds that are included in the index, even if they are constrained by some rules.
- When you buy stock in a company, you own part of it, but you are delegating the management of the company to a board of directors.
There is no such thing as a truly passive investment portfolio. You will always be dependent, to some degree, on someone else’s ability to make good decisions.
Building Your Portfolio
Let’s take for a look at an investor who builds their portfolio from the top down. After reviewing their financial plan, they’ve determined that a 60/40 portfolio makes the most sense. We know that 90% of the outcome is driven by allocation, the other 10% being investment selection. Success is also contingent upon getting and staying allocated properly, but that’s another conversation entirely.
So, what do we do with a 60/40 allocation? Do we like index funds? Active funds? How do we determine the sub-allocations? Large cap vs small cap, domestic vs international, investment grade bonds vs treasuries? And if we go so far as to choose the sub-allocations rather than buying an index fund that just buys the market for us, how do we then fill the space they occupy in our investment strategy? Do we choose mutual funds and ETFs, or do we get down to the nitty gritty and choose the individual securities that make up those market sectors?
What if your answer to these questions is “yes”?
Where, exactly, have we determined that our time, willingness, and ability to tailor our strategy has reached capacity? And what does this mean for how we maintain our portfolio?
Building even a simple 60/40 portfolio isn’t easy, and the more complex it is, the harder it is to maintain. Even simple portfolios require maintenance. If we don’t change the oil in our car, it’s not going to run for very long. If we don’t rebalance our portfolio, your primary asset manager will be the market, not you.
It’s important to know where you’ve decided to delegate – because you need to understand what responsibility that leaves you.
Investments can have correlations to each other; some move in tandem, some move inversely, and some are completely uncorrelated. And to make it a bit more complicated, the correlations aren’t stable. They usually change, with little notice, when you least expect it. Assembling a portfolio that is truly diversified requires that you monitor and manage these correlations.
If some of your investments are in funds or ETFs, you also need to determine and monitor the degree of overlap between the funds you choose. How well diversified is your portfolio based on what those managers have selected? Do you have a fund, like the S&P 500, that holds 20% of its assets in just three stocks? Is that what you intended when you bought a fund with 503 stocks in it?
Who’s really behind the wheel here?
The Consequences
What are the implications if we don’t ask ourselves these questions? What we want is a well thought out portfolio that takes all these questions into account, but what we often end up with is a collection of investments that don’t work well together.
A good place to start the investment process is to understand the limits of your own abilities and on the time you have to dedicate to this very important task. Think about what you want to delegate and what you want to keep within your purview. Make sure your strategy is appropriate for your risk appetite, which is something that only you can really judge. Make sure your strategy has a high probability of achieving your goals.
For most, it’s not just play money – it’s the difference between retiring on time and “putting on the blue vest” down at your local Walmart to make ends meet. Do you want to travel with your spouse and spend time with the grandkids? Do you want to start checking off items on your bucket list? You need to get this right.
Your nest egg should work for you so you can enjoy the life you want to live. Delegate the things you can’t or don’t want to do, understand your role and hold everyone, including yourself, accountable.
Patrick co-founded Black Arrow Capital, LLC in 2023 and serves as Head of Financial Planning.
