I want to start by defining what I mean by a successful investment portfolio and—spoiler alert—it doesn’t have to do with “beating” the market.  Success will vary depending on your stage in life (early investor vs. already retired) and your goals. Building an investment portfolio starts with defining your goals and understanding how much you’ll need to make them a reality. Once you know that, you can start to build an investment strategy that will help you reach your objective with the least amount of risk possible. We find that most successful approaches include these four elements: effective diversification, active management of asset allocation, cost efficiency and tax efficiency.

1. Effective diversification—beyond asset allocation


Traditional views of diversification tend to focus on asset classes (e.g., equity, fixed income). Although holding various asset classes can help steer you towards diversification, they don't go far enough to provide meaningful diversification benefits. Creating effective diversification requires consideration of an asset's 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 diversification strategy. 

Let's look at an example where holding different asset classes did not have a diversifying effect. Ten years ago, if you had 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 that wouldn't have protected you. The risk you held was not linked to the asset class—it was a company risk 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), your greatest retirement risk may actually come from inflation. During periods of unexpected inflation, equities and fixed-income investments may both lose money; having assets in your portfolio that generally rise along with inflation, like commodities, is a central element of effective diversification. 

2. Active management—tactical asset allocation strategy

Research shows that markets are relatively efficient—most information is already priced into the stock. This makes it difficult to predict the markets or individual stocks in the short term. However, Nobel Prize-winning research indicates that markets are actually somewhat predictable over three to five year periods.

Another way to think about this is that 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 economic 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.

3. Cost efficiency

Whether you're managing your own investments or working with an advisor, paying fees is a fact of life. So, if you're going to pay fees, make sure you're getting good value. There are several types of fees to consider including advisory and custodian fees, investment expense ratios and transaction costs—all together you could be paying almost 3% in fees annually. If you are, that's too much.

Research from indexing firm powerhouse Vanguard shows that the value of a good financial advisor may cover their fees over time. Advisors add value by building effectively diversified portfolios, monitoring markets to avoid economic bubbles and seize opportunities, minimizing the hidden 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.

4. Tax efficiency

The real measure of success for 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 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 what account types assets should be held in to take advantage of the best tax treatment based the asset. For example, assets that pay interest and ordinary dividends should be held in tax-advantaged accounts to avoid ordinary tax rates rather than in taxable non-retirement accounts where they will generate annual taxable income. Proactively harvesting losses also helps offset future gains and can further bolster your bottom line.

Crafting a Successful Investment Portfolio

While there are many ways to invest, there is no one-size-fits-all approach to investing. While building an investment strategy based on the above concepts doesn’t guarantee the outcome you want, you can know that the resulting portfolios rooted in a research-driven approach that, over time, has tended to provide the outcomes investors need.

 

Investing involves risk, including the risk of loss. 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. Past performance is no guarantee of future results. Stock investing involves risk including loss of principal.

 

This article originally appeared on November 6, 2015 on Forbes.com. You may view the article here.