Four Essential Elements Of Successful Investment Portfolios

Forbes.com, Winter, 2015. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

In my last article, I wrote about distinguishing the portfolio you want (i.e., the “magic portfolio” with low fees, always beats the market and never loses money) from the portfolio you need. While there are many approaches to investing, academic research and industry data indicate that most successful approaches have the same consistent four elements: effective diversification, active allocations and cost and tax efficiencies. Let’s look at each of these elements in more detail.

Effective diversification/strategic asset allocation strategy: Traditional views of diversification tend to focus on asset classes (e.g., equity, fixed income). Asset classes are essentially just legal definitions, and while they help steer you towards diversification, they’re not the only thing to focus on. Effective diversification requires you look at the underlying source of risk. Diversifying across the underlying source of risk, whether it’s related to the yield curve, the performance of a company or the inflation environment, is the core of a solid investment strategy.

For instance, if you had held Lehman Brothers stock in your equity portfolio and Lehman Brothers bonds in your fixed-income portfolio, you would have held assets that belong to two different asset classes, but the risk you held was not linked to the asset class—it was linked to Lehman Brothers. By implementing effective diversification as a strategy, you may be able to stabilize your portfolio by minimizing company overlap between your stocks and bonds.

While most portfolios are heavily exposed to the performance of companies (think equities and high-yield bonds), inflation may actually be the greatest risk that you face in retirement. During periods of unexpected inflation, equities and fixed-income investments may lose money; having assets in your portfolio that generally rise along with inflation is a central element of effective diversification.

Active allocations/tactical asset allocation strategy: Research shows that markets are relatively efficient (i.e., most information is already priced in), thereby making the markets or individual stocks difficult to predict in the short term. Over three to five year periods, however, Nobel Prize-winning research indicates that markets are actually somewhat predictable.

Markets that look expensive today will tend to perform worse than markets that appear cheap today and vice versa. By monitoring global markets, investors may be able to avoid bubbles and take advantage of potential growth opportunities.

Use this research with caution—tactical moves based on valuation isn’t the same as near-term market timing. There is no magic piece of evidence that tells you when to get in or out of the market. After all, what looks cheap today can get cheaper. What the research tells us is that the patient are often rewarded, but that’s not always the case.

Cost efficiency: Whether you’re on your own or working with an advisor, paying fees is a fact of life when it comes to investing. If you’re going to pay fees, make sure you’re getting good value. When you consider advisory and custodian fees, investment expense ratios and transaction costs, you could be paying almost 3% in fees annually. That’s too much!

Research form Vanguard (the powerhouse of indexing firms) shows that the value of a good financial advisor may cover their fees over time. Advisors add value by managing their clients’ feelings of fear and greed, building effectively diversified portfolios, monitoring markets for bubbles and opportunities, minimizing the opaque costs embedded in investment products, reducing clients’ tax burdens, and the list goes on.

I do think it’s possible to do better than passive indexing by using a quantitatively enhanced indexing strategy. Research shows that by having exposures like value and momentum in your portfolio, you have a chance of outperforming a purely indexed approach over time. As a result, it may be worthwhile to pay a little more for a research enhanced index than a passive fund.

Finally, if you can find a strategy that offers a positive expected return with a low, stable correlation to equity markets, it might be worth paying a higher fee for the diversification benefits.

Tax efficiency: The real measure of an investment strategy is how much of your money you actually get to keep. That’s where incorporating tax efficiencies into the investment philosophy come in. Research has shown that comprehensive tax planning can save investors 75 basis points annually. It might not sound like much, but with compounding, it’s a big deal.

One way to achieve greater tax efficiency is by increasing your use of tax-advantaged vehicles. Another approach is to use asset location strategies to minimize taxes by determining where assets should be held to take advantage of the best tax treatments. Proactively harvesting losses also helps offset future gains and can further bolster your bottom line.

While there are many ways to invest, there is no magic portfolio to be found. Even though building an investment approach based on the above concepts doesn’t guarantee the outcome you want, you can know that a portfolio built on the above concepts is rooted in a research-driven approach that, over time, has tended to provide the outcomes investors need.

There is no guarantee that asset allocation or diversification will enhance overall returns, outperform a non-diversified portfolio, nor ensure a profit or protect against a loss. No strategy assures success or protects against loss. Past performance is no guarantee of future results. Stock investing involves risk including loss of principal.

Click here to see the article on Forbes.