Successfully managing your investments is challenging. With so much uncertainty in the markets, it can be easy to simply keep score and fall into the Investment Performance Trap.

But the future is unknowable, and prudent investors understand that they have no control over the markets. Instead of focusing on and fretting about what they can’t control, they focus on what they can control. And what they can control can be summed up as the six “Ps” of prudent investment management.

1. Philosophy

Each investor, whether consciously or unconsciously, has a philosophy of how to manage money. This philosophy rests on the foundation of their core investment values and beliefs. Here at Wealth Enhancement Group, these are our core investment beliefs:

We believe there is no high-return, low-risk, and liquid investment. As much as we all want an investment that offers a high rate of return, never drops in value, and can be converted to cash daily, that investment does not exist.

We believe investor behavior is the number-one driver of investment performance. For example, an investor who sells during a down market or who buys into an overheated market can devastate their long-term returns.

We believe money is a tool to help you create the life you desire. Accordingly, we believe in a personalized portfolio that reflects your need for cash, both now and in the future, and your ability to withstand and hold on during gut-wrenching market declines.

We believe in maintaining a disciplined approach and not overreacting to current market trends, because:

  • Over time, market risk and return are correlated. Asset classes that are more volatile in the short term have a higher likelihood of achieving superior long-term returns.
  • The future is unknowable due to the unpredictability of the markets over the short-to-medium term.

We believe in effective diversification. For stocks, we believe a portfolio should hold large and small stocks, value and growth stocks, and domestic and international stocks. We understand that holding a large percentage of your portfolio in a single stock subjects you to the risk that one company might experience a sudden loss of value. We mitigate this risk by holding a basket of stocks for each asset class. For bonds, we build our portfolios around a core holding of investment-grade bonds with small positions in high-yield bonds and emerging market bonds.

We believe in global portfolios. The business and investing world are dynamic, and capital will flow to the most efficient provider of goods and services.

We believe in reversion to the mean. Reversion to the mean happens not only in the investment world, but in many parts of our life. But that doesn’t mean everything reverts to the mean. We never expect sales of buggy whips to revert to their highs of the early-1900s. Reversion to the mean, however, is a powerful recurring trend that does occur when the underlying fundamentals remain stable.

We believe in a systematic process to review and update our capital market assumptions and to use those capital market assumptions as the underpinning of our asset allocation models.

We believe in rigorous manager due diligence and an ongoing process to monitor investment managers’ people, processes, products, price, and performance.

We believe in rebalancing a portfolio to try to enhance returns over time.

We believe in asset location, tax-loss harvesting, and municipal bonds to gain tax efficiency.

2. Portfolio Design

It is critical that the portfolio’s design—its asset allocation model—aligns with the investor’s cash flow and capital needs and aligns with the investor’s ability to stay the course during down markets. Portfolio construction starts with the decision about which asset classes to include in the portfolio and which ones to exclude. Each included component serves a distinct purpose in our model portfolios, which are constructed to maximize risk-adjusted return.

The goal of prudent investors is to match assets and liabilities. Short- and medium-term cash flow needs must be supported by the portfolio’s yield and by a reserve of cash and bonds to draw upon as needed. Equities need to support long-term cash flow and capital needs. The portfolio also must reflect the investor’s risk tolerance. The goal is to have a portfolio that will limit losses sufficiently in a severe down market so that the investor can stay the course and not move to cash at precisely the wrong time—when prices have plummeted.

3. People

People matter. Effective investment management requires a team of smart, talented, and ethical people working together with a singular focus on what is best for the client. When you grow concerned about investment management, I urge you to ask yourself a few questions:

  • Does my team have the necessary intellectual firepower to do the job?
  • Is my team focused on doing what is best for me and my family, and are they acting as true fiduciaries?

If you can answer both of those questions in the affirmative, you really do have a fabulous team.

4. Process

The core tenets of effective investment management are well known. There is no secret sauce or magic pill that offers high-return and low-risk investments. The real magic pill is an effective process that the team of professionals executes.

Good investment managers will have a process that includes, but is not limited to:

  • Asset and market analysis
  • Operations and performance monitoring
  • Portfolio balancing
  • Tax-loss harvesting
  • Investment reporting
  • Customer service

5. Product

Prudent investors also look for investment managers with access to a wide range of investment products—never ones with a financial incentive to sell you one product over another. For asset classes such as U.S. equities, you want a manager who uses index funds and ETFs to garner a wide exposure to the asset class at a low cost. For less efficient asset classes like bonds or emerging markets, you want a manager who will access high-quality active managers at a very competitive price.

You generally want to avoid managers who sell proprietary products from their own company. The truth is, those proprietary funds are often quite profitable for the company, and it is difficult to fire your own manager if the situation warrants removal.

6. Performance

Performance should only be one metric used to monitor your investment manager and portfolios—not the only metric. Think of it as an early warning signal. When an investment manager’s performance falls out of line with our expected returns, it prompts us to reach out and investigate the cause of the performance differential. This is equally true if the manager is dramatically underperforming or outperforming the appropriate benchmark.

In many cases, a significant performance gap can indicate that your manager has strayed from their investment style or has created a highly concentrated portfolio where one or two stocks are having a disproportionate impact on their returns. If the manager has changed their approach without discussing it with you first, it is likely you’ll be looking for a new one.

Focus on Essentials

We always want to focus on what really matters. Because markets are often unpredictable over multiyear periods, comparing your portfolio to another is not an effective way to measure the competency of your investment manager.

Instead, it’s important to focus on your comprehensive financial plan and how it’s helping you work toward your long-term financial goals. Prudent investors know that achieving these goals is a marathon—not a sprint—so it’s important to trust in your financial advisor and the plan that you two have carefully constructed.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Rebalancing and asset allocation do not ensure a profit or protect against a loss.

David Geller

David Geller

Director, Behavioral Wealth Management

CFP® David joined Wealth Enhancement Group through the partnership with JOYN Advisors, where he acted as CEO and Co-Founder. He is the creator of the Behavioral Wealth Management™ model. A model that focuses on aligning wealth management with the integration of human emotions while taking into consideration an individual’s talents, wisdom, network and relationships. David has been featured in a number of prominent outlets including The New York Times, The Wall Street Journal and The...Read More