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  • Writer's pictureJiayi (Kristy) Xu, MBA, CFP®

Introduction to investment techniques used in portfolio management

Many prospective clients already have investment portfolios prior to contacting me. For younger clients, this could be a few stocks that they purchased as a hobby that is worth a fraction of their annual income, while for clients who have been accumulating wealth long enough this could be a portfolio of investments acquired over the past decades that are worth many multiples of their annual income. Some of my clients have expressed concern in our first meeting that the pre-existing holdings in their investment portfolios are not completely suitable to their current financial situation and/or are not contributing to their financial goals. Below, I will introduce a few concepts and techniques that are applicable to some of my client’s most common questions.

How do I ensure the asset (class) allocation matches my objectives and constraints?

Asset allocation focuses on determining the mixture of asset classes to invest in which will provide a combination of risk and return that is optimal given an investor's financial situation and investment objectives. An asset class is a grouping of securities with similar characteristics, such as stocks, bonds, and money market instruments. Many studies have revealed that well over 90% of return variability is due to asset (class) allocation, and less than 10% of the return variability is made up of specific asset selection and market timing. The asset allocation of your portfolio should align with your objectives and constraints. For objectives, you need to set your:

· Return objective (what return do you expect to receive from your investment portfolio)

· Risk objective (how much risk you would be willing take for your desired return)

For constraints, you need to consider your:

· Time horizon(s)

· liquidity requirements

· Legal/regulatory

· Taxes

· Unique needs

You should also consider your goals, financial assets, and projected cash flows to determine the return portfolio required in order to meet your savings and spending objectives. All of these analyses should, of course, account for paying taxes and exposure to inflation because even minimal amounts of inflation (assuming we will return to that world one day) will cause huge reductions to purchasing power over long periods of time. The risk/return relationship must be considered, as higher required returns usually demand higher exposures to risk, and that level of risk cannot exceed the client's degree of risk tolerance and risk aversion. (Existing clients of Global Wealth Harbor have completed an Investment Policy Statement (IPS) with me in which we clarify and define clients’ specific objectives and constraints for their asset allocations.)

The first step of asset allocation process is the development of a strategic asset allocation (SAA). SAA identifies asset classes and the proportions for those asset classes that would comprise the normal portfolio mix for the investor's stated time frame. After you set your target allocations for various asset classes, you rebalance the portfolio periodically to the original allocations when they deviate significantly from the initial portfolio mix due to differing returns from the various assets. SAA can be enhanced by adding tactical asset allocation (TAA) approach. Tactical asset allocation (TAA) comes after SAA, as it involves planning for deviations from normal long term asset allocation. TAA establishes policies to govern dynamic reallocations of a temporary nature – an active management portfolio strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors. For example, SAA would suggest a classic 60% stock/ 40% bond portfolio over the long term for a middle-age median income family. A TAA add on would suggest moving to 70% stock/ 30% bonds during a period where rising interest rates and strong stock returns are expected for some time. As this view changes, the portfolio would shift to different direction or back towards the SAA.

How to protect my portfolio during market uncertainty?

As the last few market cycles have shown, the predictability of market moves can be hard, and more importantly, the movements can occur quickly, making it hard to time or reposition.

Dollar-cost averaging is the practice of purchasing a fixed dollar amount of stock or stock funds at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you'll be averaging out price fluctuations by buying more shares of common stock when the price is lower, and fewer shares when the price is higher. Dollar-cost averaging is a natural component of a savings plan of someone who invests a certain amount every month for a specific period of his or her life. It also works well when you received a large lump sum (from a monetary settlement, retirement distribution, rollover of retirement assets, inheritance, or monetary windfall) to invest and afraid of getting into the downward trending market.

A bond laddering is to structure bonds in your portfolio to mature at regular intervals throughout the various maturities of the yield curve. To perpetuate a ladder structure, as each bond matures, the proceeds are used to purchase a bond that will mature at the next interval after the one with the longest maturity in the portfolio. Ladders are most effective when the yield is normal or sloping upward and interest rates are fairly stable. This strategy is for risk-averse investors looking for income over growth. Since bonds are coming due at regular intervals, an investor is never at risk of having an entire portfolio come due in a lower interest rate environment and there will always be some money to invest when rates are higher.

How to take advantage of market cycle?

Sector rotation is an active - tactical investment strategy that seeks to take advantage of the outperformance and underperformance that occurs in specific areas of the market during market cycle phases. The four market cycles are 1) expansion, 2) peak, 3) recession, and 4) trough. The advantage of this strategy is that timing the market cycle and reallocating capital into sectors that have the opportunity to outperform from sectors that will underperform leading to performance that is better than indexing or buy and hold alone. The challenge with sector rotation strategies is that timing a market cycle on a predictive basis is rather difficult to do. Also, when you are employing this strategy, to ensure that you have a diversified portfolio, you should own in some amount in all of the sectors, but overweight and underweight the sectors expected to outperform or underperform.

How to use my investment portfolio to fund goals that have different priorities?

The advantage of using a core-satellite structure is that you can have a core portfolio and (a) satellite portfolio(s) and they do not need to be in different accounts. In general, a core is either a "buy and hold" or an indexed investment strategy that is rarely modified other than rebalancing. This portion of the strategy tends to follow a strategic long term investment philosophy that is used to fund your goals that are “needs”. Around the core is a portfolio or collection of several portfolios that are considered satellites. These satellite portfolios can range in investment strategy to include any number of other investment styles or strategies. For example, a satellite may consist of a tactical sector rotation portfolio while another may include private equity investments. There is no real limitation with how many satellite portfolios you may have. You can use your satellite portfolios to fund goals that are your “wants”.

Conceptually, the core portfolio serves to create a more predictable/traditional long term investment return stream while also lowering total portfolio cost, taxes, and risk. The index portfolio that serves as the core portfolio generally act as if the security markets are relatively efficient. In other words, their decisions are consistent with the acceptance of consensus estimates of risk and return, which is why they are predictable. The passive index portfolio is used to match the designated benchmarks instead of outperform it. Keep in mind that passive portfolio not only include the traditional index (such as the S&P 500), but can also be structured based on stock characteristics such as risk level, value, or growth potential. These variations enhance the performance of your core portfolio.

The satellite portfolios, on the other hand, seek to provide alpha, or outperformance, by taking on more risk or investing in more niche market areas. The actively managed satellite portfolios are based on the theory that from time to time there are mispriced securities or groups of securities. Investor use deviant predictions, that is, their forecasts of risks and expected returns differ from consensus opinions to take advantage of the market inefficiency. Note that some securities are more suited for passive strategies than others. For instance, mega-cap stocks have a more efficient market according to the Efficient Market Hypothesis (in an efficient market, information is quickly and widely disseminated, thereby allowing each security's price to adjust rapidly in an unbiased manner to new information so that it reflects the investment's intrinsic value), so they are more suited for passive investment than small-cap companies or private equity investments with lower liquidity.

Therefore, core-satellite investment strategy is a way to account for various goal priorities. For example, retirement income goal assets may be placed in a core portfolio because retirement goal is a need when predictability is the key, while satellite investments represent legacy or aspirational investments goals that are wants, enabling more creativities in developing the portfolio.

What information should I look at if I want to actively manage my stock portfolio?

Fundamental analysis looks at the fundamentals of the business, which are best disclosed on the financial statements, the balance sheet and the income statement. The fundamentalist tends to look forward and is matters such as future earnings and dividends. Fundamental analysts forecast, among other things, future levels of the economy's gross domestic product, future sales and earnings for industries, and future sales and earnings for companies. For example, an estimate of next year's earnings per share for a firm may be multiplied by a projected price-earnings ratio in order to estimate the expected price of the firm's stock a year hence. Or an estimate of future dividends may be supplied to a dividend discount model. Both approaches will allow you to make a direct forecast of the stock's expected return.

Top-down forecasting approach and bottom-up forecasting approach are both frequently used analysis and you can use them together. With top-down approach, you first involved in making forecasts for the economy, then for industries, and finally for companies. With bottom-up approach you begin with estimates of the prospects for companies and then build to estimates of the prospects for industries and ultimately the economy. You can combine them by making forecasts of the economy in a top-down manner. These forecasts then provide a setting within which I make bottom-up forecasts for individual companies. Each of the individual forecasts need to be consistent and if it is not, the process is repeated (perhaps with additional controls) to ensure consistency. Of course, some level of constraints must be placed on both investment managers that follow top-down or bottom-up processes for diversified investment portfolios. A portfolio of all tech stocks because they have the best financial ratio statistics may not be appropriate. You need to combine this process with the objectives and constraints you have to control risk and concentration.

How to have a tax-efficient portfolio through tax loss harvesting?

A commonly used strategy to minimize taxes is to offset realized gains by “realizing" or "harvesting" losses to offset the gains (and reduce tax cost). Not only can capital losses offset capital gains, but if losses exceed gains that year you could also use the remaining capital-loss balance to offset personal income or even carry the loss over to offset gains in future years. Sometimes, when a loss is harvested, the intent may be to purchase the security back. Note that when doing so, you must be aware of the Internal Revenue Service (IRS) rule prohibiting a taxpayer from claiming a loss on the sale of an investment when a "substantially identical" stock or securities was purchased within 30 days before or after the sale date. This is known as the "30-day wash-sale rule". The purpose of the wash sale rule is to prevent taxpayers from generating artificial tax losses in situations where taxpayers do not intend to reduce their holdings in the stock or securities that are sold.

How to modify my existing portfolio that is not well-diversified?

If your portfolio is currently concentrated in a single stock such as your employer’s stock or a holding you have built up over time, do not feel stresses – you do not need to replace it all at once in order to achieve your objectives and constraints. Even when you are approaching retirement, you can still use the time defined asset pool approach to gradually reallocate your portfolio to a desirable allocation without overly sacrificing the growth opportunity of your portfolio. Under this approach, you divide your existing portfolio into pools that are each assigned to fund a specific portion of your retirement (for instance, the first to the fifth years of your retirement, the sixth to tenth year of our retirement, etc.) and invest accordingly based on the time horizon to the pools assigned for the retirement segment. Your high growth holdings are assigned to fund the later phases of your retirement (if you expect that holding will continue to grow) and income generating holdings are assigned fund your earlier periods of retirement. Then we will reallocate your holdings each time the next planned period of your retirement approaches so that there will always be a part of your portfolio generating income for your needs while you get to keep the part that is your high growth holding for as long as possible to achieve a greater portfolio value.

With all the techniques discussed above, please keep in mind that portfolio management is a continuous process that need strategic implementation, constant monitoring, and prompt revision in an environment of changing market conditions and changing individuals’ circumstances. Let me know if you would like to discuss any above techniques in further details or if you have questions about how to employ them in a way that is suitable for your specific situation. I am also happy to chat about investment techniques that you are interested in that are not addressed in this blog post.

If you would like to discuss your investment portfolio with me but are new to my firm, let’s set up a free introductory call!


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