investment process

Step One: Determine the Required Rate of Return

As Yogi Berra once quipped, "If you don’t know where you are going, you will wind up somewhere else.” If you don’t know what rate of return you are targeting, how will you know if your portfolio is appropriate and if your overall strategy is working? Often investors incorrectly compare their success to an index like the Dow Jones or the S&P 500. Most people do not want or need all the risk that the “stock market “possesses, nor should they take it. Determining your required rate of return is the most crucial step. As you get closer to retirement, downside protection with an exit strategy becomes critical. It’s too hard to make the money back.

Step Two: Determine the Risk Tolerance

After determining your required rate of return, the focus turns to the subject of risk. Specifically, how much risk must you assume in order to reach your required return? The answer is simply to take the least amount of risk necessary to achieve your objectives - Period. Greed always takes over when we think about how much we “could” make if everything went perfectly. It’s often not until the market crashes do we realize that we are taking too much risk.

Step Three: Determine the Broad Allocation

The goal of allocation optimization is to find the portfolio which offers the highest expected return for a given amount of risk or the least amount of risk for a given level of return. I spent my early years with a large wire house firm where we were taught to invest in stocks, bonds, and cash. That was it! There wasn’t much discussion about alternative investments. I also recall that an aggressive portfolio was 85% in stocks and a moderate to aggressive portfolio had 70% in stocks. Obviously that worked during the bull markets of the 80s and ’90s, but if you were holding that much in stocks when the recent bear came growling, your portfolio got mauled. Moreover, if you lost 50% in a year, you would then need to earn 100% just to break even. Therefore, in my view, managing the downside risk is the single most important thing I can do for my client’s portfolio. Any plan must have an exit strategy.

Therefore, in portfolio construction, I search for assets with a good risk/return relationship and a negative correlation to each other as well as assets with a low correlation to the broader stock market. My ultimate goal is to find the combination of assets that protects well on the downside and lets the upside take care of itself.

Step Four: Select the Subcategories

After you determine the broad allocation, you must choose the subcategories. Most of us are taught to diversify over a number of categories. What we’ve learned is that diversification does not protect.

Stocks

I favor different categories or sectors depending on economic and market conditions. Once it’s decided how much will be allocated to stocks, the next decision is made towards how much goes into each sector: large, mid, small cap, value, growth or blend. I often prefer to use ETF’s as they provide the ability to select a perfectly diversified sector and sub-sector also does not correlate with the other sectors. Too often people believe they are diversified just by owning a lot of stocks or mutual funds, only to find they correlate too much or the funds all own the same things. Your investments must adapt to changing market conditions. I also will go to cash during dangerous periods.

Bonds

For bonds, I invest in the best after-tax returns with the shortest maturities available. These include tax-free bonds, short to intermediate corporates and TIPs. (Treasury Inflation Protected).  My goal here is to achieve a positive return with the bonds no matter how interest rates are trending.  Currently I’m getting double-digit yields in short term bonds with maturities of just 3 to 5 years, so why take the risk? There’s no inflation now, but when it comes back, longer bonds will lose value. 

Alternative Investments

Although real estate could easily be included in the stock category, I place it here. Other alternative investments include managed futures, Master LP’s (which have dividends that are 85% tax-free), currency ETFs, commodity funds and ETFs, and long-short or market market-neutral funds. As I mentioned, I seek assets that are not highly correlated with the broader stock market.

Step Five: Select the Specific Holdings

In selecting the specific holdings, I use our proprietary process for building tax-efficient portfolios for high net worth individuals. I have many expensive tools at my disposal that are unnot available to individuals. The institutional version of Morningstar’s Office Edition includes a robust research tool. Lowry’s Independent Research, which has been around since 1938, provides the best technical analysis I know of. I also have access to Bloomberg, Allocation Master, Zacks and JPMorgan research to name just a few. My 25+ years in the business allows me to find opportunities that others can’t. The specifics will depend on the current economic and market environment, and my outlook for the short, intermediate and long term. 

Step Six: Implement the Portfolio

I take a tactical approach, as opposed to a buy-and-hold style. A tactical approach means hands-on portfolio management, which over-weights and under-weights different market allocations based on the economic environment, and uses cash during dangerous times. A buy-and-hold asset allocation style dictates buying many investment categories and holding them regardless of market conditions. Our trademarked Top-Down Tactical (TDT™) investment management strategy is built for today’s economic environment. 

Step Seven: Monitor the Portfolio

When monitoring the portfolio, I constantly examine the broad allocation as well as the underlying holdings. Although I conduct client reviews quarterly, I am constantly monitoring each account. The bottom line to me is the advisor’s version of the Hippocratic Oath, “Provide safety, security and peace of mind."

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