All the investments you hold together make up your portfolio. This can include a variety of asset classes. Two individuals with different investment objectives are likely to have large differences in their portfolio – this isn’t all that surprising. Unexpectedly, people with similar investment objectives often have substantially different portfolios due to differences in style of management and the types of asset classes owned. As you view your own investments, it can become extremely clear why portfolio management is important.

Choosing investments that meet your objectives seems like an obvious goal, however, it’s not the same as designing and managing a portfolio that best achieves your goal. Many investors choose their holdings one at a time when a balance becomes available to invest. For these investors, the choice of buying an investment or passing on the opportunity is a yes/no decision. The problem is that all these holdings acquired over time may not work well together to meet specific objectives. They may also be taking more risk than necessary to meet their desired objectives. There are several steps an investor will wish to follow to ensure their portfolio is effectively managed over time.

The first of these tasks is to decide why to invest at all – these are your investment objectives.

Your investment objectives are what you hope to achieve with your money. They are the fundamental starting point from which to design an initial portfolio or change it over time.

What do you hope to accomplish?

One investor who hopes to replace his paycheck in retirement may manage a portfolio differently than another investor who hopes to preserve a legacy that provides for children or grandchildren. Your goals might even change over time. We generally hope to accumulate and grow our money when we are young and then preserve and spend at a later point in life. Establishing these goals can give us objectives to manage our portfolio toward.

This will involve several decisions that lead to the second task of deciding what types of assets may be appropriate.

Asset Allocation

Choosing an asset allocation is one of the most important decisions an investor can make. What types of asset classes make up your portfolio and in what amount? Often the decisions that go into selecting an asset allocation can be counter-intuitive. Investors often question why certain asset classes need to be present in their portfolio at all.

Should they just choose the assets that most clearly meet their objectives and leave out the other types which appear inappropriate at first glance? Not necessarily.

Goal Example #1 – Current Income

Let’s consider an investor whose goal is to receive income from his portfolio today, anticipating this as an objective for the remainder of his life. It can seem natural to select only those investments providing the greatest current income, possibly selecting an all-bond portfolio.

Why hold any growth stocks, or even income producing stocks if the yield is less than that provided by the purchase of additional bonds? The reason is that even though the portfolio’s initial objective of receiving current income may be fulfilled adequately by selecting all income-producing assets, it may not continue to do so effectively over time due to inflation. This can be especially relevant for those seeking to receive income during an extended retirement. Adding equities may not directly produce income, but they will achieve a secondary objective of helping the portfolio withstand the effects of inflation.

Goal Example #2 – Growth

Another investor may have growth as their primary objective. Why hold anything not likely to experience substantial appreciation? Such an investor may be tempted to select an all-equity portfolio just like as our previous investor was tempted to invest exclusively in bonds for current income. What would the flaw in this investor’s logic be?

Selecting assets on the exclusive basis of their likelihood of appreciation should most likely provide a hedge against inflation over extended periods. However, there are other reasons why this investor may wish to opt for a broader asset allocation. This is because the desired returns may be achievable with less risk. If you can design a portfolio with an expected return meeting that meets your requirements with less risk, why take more risk than necessary?

Diversification

In both situations, we can see the importance of diversification. Different assets have distinct functions in a portfolio. Our income investor did not need equities to produce income but rather to hedge against inflation. Our growth investor did not need bonds because of their potential for appreciation but to provide stability and minimize risk to a level appropriate for the desired return.  Choosing asset classes based on function within the portfolio is important but you should also consider the advantages of diversity among asset classes since they are often not correlated with one another.

Choose Uncorrelated Assets

Choosing assets that are not heavily correlated to one another is important to reduce overall risk in your portfolio. Assume you have two portfolios with the same expected return over time. The rational investor would likely choose the one with the least amount of risk. Why not have a smoother ride along the way? Over extended periods of time, most assets in your portfolio may have performed well, but from year to year, it can be anyone’s guess. By owning multiple non-correlated asset classes, you can reach your return goals and let the difference in performance year to year between assets smooth out the return for you.
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Another important decision you’ll need to make is the investment style to be employed in your portfolio.

While it is certainly possible to mix and match investment styles, be sure you’re not doing so arbitrarily. You should know why you are making exceptions in addition to why you made your initial decision for the style of management you hope to employ. For many investors, a fundamental choice in their portfolio is the decision to use an active or passive investment strategy. The debate about the merits of active vs passive management styles is one of the most heavily debated issues in finance. We’ll certainly not solve this debate here, but it is important to understand the key arguments on each side.

Active Management

When one decides to engage in active management, this implies that the investor believes there are inefficiencies in market pricing that investors can potentially detect and take advantage of when making decisions in their portfolio. To put it simply, it is possible to make superior selections over time that are not simply related to chance.

Passive Management

Those who take a passive investment strategy believe that markets are efficient, and that superior evaluation of investment information will not lead to outperformance of the market in the long-term. All available information about investments will be reacted to by the market by numerous market participants at the same time. Those who support the Efficient Market Hypothesis recognize that there are often examples of superior performance by portfolio managers. Although it’s important to highlight that with many examples of portfolio management, some amount will always outperform by necessity. They point to the fact that past performance is not an indicator of future results as a reason to engage in passive investment strategies rather than attempt to outperform the market.

There are additional arguments for passive management, such as the fact that even if active managers outperform, they must do so by at least the amount of transaction costs and taxes that are caused by their activity. Those who advocate active management counter with the difficulty in applying passive strategies to markets that are less liquid as well as some of the practical difficulties created in the market by products designed for passive management strategies. Although there are investors who consider themselves in one camp, many investors believe that markets are generally efficient with the occasional opportunity to achieve superior returns by engaging in active management.

Investors should also consider the tax implications of their investment decisions and design their portfolios accordingly.

Investments sometimes result in taxes, so we cannot forget to take this into account. It’s important to consider the topic of tax diversification, the idea that there are different pools of money and that they are taxed differently than one another. The decision of what account types to place certain assets is called asset location, not to be confused with asset allocation, a topic we discussed earlier regarding which assets are selected. Your asset location decision will have a significant impact on your portfolio.

Tax Diversification

In the United States, we have three primary “pools” of money. They are the tax-free pool, the tax-deferred pool, and the taxable pool. An investor with a Roth IRA, traditional IRA and regular non-retirement investment account (often called “non-qualified” or “non-qual” accounts) would have all three pools – each of which has different tax treatment. Many investors understand the importance of diversity of asset classes in their portfolio but not necessarily the importance of tax diversity. Once the portfolio is utilized in or before retirement, there will be a greater opportunity for flexibility in choosing withdrawal sources depending on the tax situation at that point in time.

Which Tax Pools?

Managing a portfolio for tax efficiency involves several decisions. One should consider tax diversification among the “pools” and make their asset location decisions based on their tax situation. While you shouldn’t make investment decisions exclusively based on tax considerations, they should be a key factor in the decision-making process. Considering the tax implications of your decisions before implementation in your portfolio can increase your after-tax return.

Assume you have decided to hold a certain amount of fixed income, some of which will be in accounts that are taxable. You would like to receive the highest rate of return for these assets consistent with your risk tolerance but also considering your tax situation. An investor who is consistently in the lowest tax brackets may wish to select corporate bonds or other higher yielding fixed income options. An investor with a similar portfolio who is more often in a higher tax bracket may wish to select tax-free municipal bonds for this portion of their fixed income need, particularly if they reside in a state with a high tax liability. They may experience a lower nominal return but a higher return after tax.

Example

Investors will also consider the tax implications of sales occurring in non-qualified accounts. This may include opportunities for tax loss harvesting. By selling assets that are down in a portfolio and replacing them with similar assets (the same asset can’t be repurchased within 30 days to avoid being considered a “wash sale”) you can maintain the overall integrity of your portfolio while also taking a loss that can be used to offset gains in taxable accounts. If no gains exist, a limited amount of ordinary income (such as income from wages or withdrawals from deferred accounts) can be offset each year. If you have a year with very little or no tax liability, you can consider gain harvesting.

This involves intentionally selling an asset and repurchasing it at again to reestablish a higher cost basis, potentially lowering future tax liability when the asset is ultimately sold for good. This strategy can be convenient since the same asset can be purchased immediately without waiting 30 days. (The “wash sale” rule applies to losses but not to gains.)

Conclusion

As you can see, there are several factors relevant to successfully managing a portfolio, including but not limited to which asset classes to select, how to diversify, what management style to employ, and how to consider tax implications. Some investors enjoy managing their own portfolios, but others do not have the time to do so and recognize the benefits of working with professionals. Consider a complimentary consultation with a CERTIFIED FINANCIAL PLANNER™ professional at Pure Financial Advisors to discuss best practices for your own portfolio as well as how these decisions may affect other aspects of your financial life such as tax and estate planning.

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Disclosures

Intended for educational purposes only and are not intended as individualized advice or a guarantee that you will achieve a desired result. Before implementing any strategies discussed you should consult your tax and financial advisors.

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.

 

About the Author

Financial Educator

CFP®, AIF®

Jason has been involved in the financial services industry as an advisor and financial educator for more than ten years. Prior to joining Pure Financial Advisors, Jason taught in the Financial Planning program at the...