In this video, Pure Financial Advisors’ Director of Research, Brian Perry, CFP®, CFA® outlines the 5 top portfolio management techniques: conservative, moderate, aggressive, income-oriented, and tax efficient. Brian discusses when and how you might use each of these five techniques and how to decide which one best suits your financial goals.
Important Points:
(00:50) – Conservative Portfolio Management Strategy
(01:16) – Time Horizon and Risk Tolerance
(01:25) – Intermediate Approach
(01:39) – Growth Approach
(02:15) – Income-Oriented Approach
(02:33) – Ways of Generating Income: Total Return Approach and Dividends and Interest Approach
(03:17) – Tax Efficient Approach
(03:56) – Two Main Types of Assets: Growth and Safety
(06:25) – Financial Planning First, Investing Next
Transcription:
So, today we’re going to talk about five main techniques for portfolio management. And we’re going to look at when you use these, how you might incorporate them into a portfolio, and how you might build these types of portfolios. So how do you decide which of the five main techniques to use? Well, really, it depends on your goals. As with anything in portfolio management, the journey depends upon the destination. And so the first thing you want to do, as always, fall back on your financial planning. What does your financial planning say that you’re trying to accomplish? What is your goal? What is your destination? That’s what’s going to drive the technique you use in order to get there.
Five main types, like I mentioned. We’ve got conservative, we’ve got moderate, we’ve got aggressive, we’ve got income-oriented, and then we’ve got tax-efficient. Let’s take a closer look at each of those five now in order, starting with conservative.
Conservative Portfolio Management Strategy
When would you use a conservative portfolio management tactic? Maybe you’ve got a short-term time horizon. Maybe this is college savings. Your child is in high school and you’re looking at paying for college, you want to be conservative. Maybe you want to focus on principal preservation because you can’t afford a large loss. Again, the college example. Maybe this is a home purchase. Maybe you’re buying a home in the next couple of years. You don’t want to put your principal at risk. We’ll look more at the techniques you might use to get to a conservative strategy. But again, time horizon and risk tolerance are going to play a large role in determining whether or not this is the right approach. So, if you’re not conservative, what are you? Maybe you’re an intermediate approach.
Intermediate Portfolio Management Approach
An intermediate approach, as the name implies, it’s your mix of aggressive and conservative, somewhere in the middle. Here, you’re focusing on some growth, yeah, but also some principal preservation. This is your moderate approach, your moderate risk tolerance.
Growth Portfolio Management Approach
And then you’ve got your growth approach. This is more aggressive. This is when you’ve got a long-term time horizon, you’re willing to tolerate some fluctuations, you’re willing to see your portfolio bounce around, up and down, with the hopes that in the long run it will generate higher returns. Importantly, this isn’t the portfolio management approach of “swinging for the fences”. Swinging for the fences or trying to hit the proverbial home run usually isn’t really a portfolio management technique, it’s a gamble. What we’re talking about here is managing risk, taking a little bit more risk than average, in order to generate higher returns, but doing it in a prudent manner, taking risks that are well-rewarded and still within a diversified portfolio.
Income-Oriented Portfolio Management: Total Return Vs. Dividends & Interest
Then we have the income-oriented approach. This is where you’re not so worried about future growth, you’re worried more about putting dollars in your pockets, money you can spend, in your bank account every day from your portfolio. Maybe this is in retirement, maybe this is just cash flow you need to live off of. And then when we’re talking about income, there are two main ways of generating that: there’s a total return approach and there’s a dividends and interest approach.
Dividends and interest, that’s when you’re just clipping the proverbial coupons from your portfolio. Your portfolio is kicking off cash in the form of dividends, interest payments, and the like, you spend those, you don’t touch the principal.
The total return approach, that’s where not only are you maybe collecting coupons in the form of dividends and interest, you might be selling some securities, harvesting some gains, choosing how to generate that cash flow from your portfolio. For many people, that total return approach is a more reasonable approach to follow. Dividends and interest only, there are some flaws to that. For some people it works, but for many, that total return approach to generating income is the way to go.
Tax-Efficient Portfolio Management Approach
And then the final portfolio management approach, tax-efficient. So this is where your primary goal isn’t just returns, it’s returns net of taxes. Now, to be fair, taxes should be a consideration in almost any of your portfolio management approaches, assuming you have some assets in taxable accounts, but here, this is the main focus. Maybe you’re in a high tax bracket, maybe you have other sources of income that are going to push your adjusted gross income up and you want to make sure that what’s coming out of your portfolio is tax-efficient. Maybe here you’re focusing on qualified dividends or long-term capital gains for tax-efficiency, maybe you’re focusing on municipal bonds for tax-efficiency.
Types of Assets: Growth and Safety
Those are the main portfolio techniques, let’s talk about the building blocks – how do you get to those portfolios? And here, you’re talking about really two main types of assets. People talk about all different asset classes, asset types. I focus on two: I focus on growth and I focus on safety. And when I talk about growth, these are your assets that, as the name implies, are intended to grow. They’re intended to generate higher returns over time. With those higher returns does come some higher levels of volatility, of course. It’s a trade-off, like everything. You don’t get something for nothing when it comes to investing.
What kinds of assets fall within the growth pool? Well, I might look at things like stocks. I might look at things like natural resources. I might look at things like real estate. I might look at things like alternative investments as asset classes designed to generate more growth from your portfolio.
And then in addition to growth, you have your safe assets. These are the assets that are designed to preserve your principal, not fluctuate as much, perhaps provide a solid foundation upon which your growth assets can rest. These are things like cash, perhaps, and these are things like high-quality bonds. Notice that word I used, high-quality bonds. Aggressive bonds, your high yield bonds, your emerging market bonds, your preferred stocks, those should be part of the aggressive or the growth pool. When you’re focusing on safety in the bond market, you want those shorter and intermediate term high-quality bonds, because that’s really where that safety and that stability is coming from.
How you choose to combine these growth assets and these safe assets will, to a large degree, depend on which of the portfolio management techniques you’re focusing on. If you’re focusing on a growth portfolio, you’re going to want, obviously, more of the growth assets, less of the safe assets. If you’re focusing on the conservative approach to portfolio management, you’re going to want more of the safe assets, less of the growth assets, of course. And then in the tax-efficient or the income-oriented, it’s going to be a combination of both, and determining whether or not those assets will help you accomplish the additional goals of tax-efficiency and income generation, depending on which of the portfolio management techniques you’re going for.
Once you’ve determined what mix of growth and safety you want, of course, it’s how do you then implement it from a vehicle perspective? And that’s the topic of another article, another video. But importantly, of course, there are multiple approaches. Some will use actively-managed mutual funds. Some will use indexed mutual funds. Some will use our preferred approach, which is an institutional approach, of mutual funds and exchange-traded funds designed to capture market returns while overweighting factors that have proven to generate higher returns in the long run. Some people buy individual securities, that can work for some, but that vehicle selection comes after determining your mix of growth and preservation.
Financial Planning First, Investing Next
And then of course, as you put this all together, you need to determine which of the portfolio management techniques is right for you. And that circles this all back to the financial planning, which is, what are your goals? What is your risk tolerance? Importantly, what is your required rate of return? When you ran your cash flows, when you did your financial planning, what rate of return do you need to meet your financial goals? Because, to a large degree, that’s the number that’s going to determine whether you want an aggressive portfolio, a conservative portfolio, an income portfolio, etc.
And then, where do your assets lie? What kind of tax bracket are you in today? And what kind of tax bracket are you going to be in the future based on your tax projections and your tax planning? Because that’s going to determine whether or not that tax-efficient portfolio is the one to focus on.
As you can see, and as always, investing is a very important discipline, but it’s one piece of the larger pie. Investing takes place within the context of your financial planning, because without the financial planning, you’re not going to know which portfolio management technique is appropriate for you.
So in order, first you do your financial planning, that leads you to which portfolio management technique is appropriate for you, then having determined which is the appropriate portfolio management technique, whether it’s conservative, intermediate, aggressive, whether it’s tax-efficient or income generation. You then figure out, based upon that, what mix of safe and growth assets is appropriate for you, what proportions. For most people it’s going to be some mix of both. And then finally, what vehicles will help you implement the strategies you’ve chosen?
So there you have it. Five main types of portfolio management technique, ranging from conservative to growth, incorporating perhaps tax-efficiency or income generation as a goal, and then determining what mix of growth and safe assets is appropriate to get you there. For more on this topic or on any others, visit us at Pure Financial.
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