FMD Capital Management

Sensible Tips For Constructing A Well-Balanced Portfolio

Written by David Fabian, March 27th, 2017

Constructing a well-balanced portfolio is a fine art that can be lost among the shuffle of collecting individual positions.  Too often, investors are more concerned about finding the right stock or jumping on a new trend, rather than analyzing how it fits within their accounts.

Jumbling together a random series of stocks or funds without any sense of cohesion makes it more likely that you will abandon them at random (inopportune) moments.  That path leads to uncertainty of past decisions, weak correlation with the markets, and streaky performance at best.  Instead, matching all the right pieces together to suit your risk tolerance and investment strategy will have a meaningful impact on your behavioral choices through good times and bad.

Great investors think of themselves as organizers rather than collectors.  They may still shuffle their positions over time.  However, there is a method to the madness that makes for a strong navigational tool even when you are uncertain about market direction.

One way to do this is to create imaginary buckets, or sleeves, for each asset class.  Stocks, bonds, alternatives, and cash are the four most common types of asset classes found within a conventional investment portfolio.  Alternatives may include commodities, real estate, income generating assets like preferred stocks or MLPs, hedge funds, options, and even private equity in some instances.

Once you have identified and placed each investment in those categories, you need to measure the allocation of each sleeve and individual position sizes of your holdings.  There is no perfect asset allocation for every investor.  Some may be comfortable owning 100% stocks, while others are happy with 25% stocks, 50% bonds, 15% alternatives, and 10% cash.  It’s all about understanding the risks of each sleeve and comingling them to serve your individual needs.

For those that prefer to take a more active tactic with their portfolios, it is important to consider minimum and maximum exposure limits for each sleeve as well.  This ensures you remain correlated with the markets and your overarching goals, while staying balanced in your asset allocation approach.  Without these bands (or guidelines), it becomes easy to justify taking too much risk when things are going well or holding an excessive amount of cash when the markets appear more volatile.

In general, greater diversification tends to lead to less volatility over time.  That doesn’t mean it produces the best results.  It simply means there are going to be narrower price fluctuations as diverging performance characteristics exert itself on each sleeve.

Another attribute of great investors is they only focus on the things they can control.  Market trends, central bank policies, political machinations, weather, war, and other global risks can’t be consistently forecasted.  However, it is within your control to determine security selection, position sizing, entry or exit points, and any risk management triggers.

My preferred investment vehicle for assembling a well-balanced portfolio is exchange-traded funds (ETFs).  These tools offer a low-cost, liquid, tax-efficient, and transparent method of investment exposure in each of the asset classes mentioned above.  You get instant diversification with just a few ETFs rather than the complicated means of picking individual stocks or high fees of most mutual funds.

If you are new to ETFs, here is a primer on what they are and how they work.

I often urge investors that picking the perfect ETF isn’t as important as choosing positions that you can stick with through all conditions or that fit within your investment methodology.  There are always going to be funds that are doing slightly better than yours or that save you a few basis points in fees.  So what?  Exposure, timing, and a better decision framework will always trump those minor details.

The Bottom Line

Experienced investors may scoff at the importance of assembling these asset allocation guidelines and investment exposure criteria.  However, the truth is that you are probably already doing this work in your head whether you want to admit it or not.  It becomes second nature once you get into the practice of dividing up each sleeve and understanding the pros and cons of any adjustments therein.

It’s also important to understand that a balanced portfolio may never truly be firing on all cylinders.  The effects of diversification are such that some components will be doing well, while others start to fall by the wayside.  That doesn’t mean you should always abandon those temporarily weaker funds that are provide meaningful core exposure.  It may simply be that they don’t fit in the current environment, but will prove their worth in other ways such as reducing volatility or providing income.

In my own practice, I am constantly refreshing these details to ensure my portfolios are balanced and sensible given the prevailing market conditions.  In addition, I always advocate making incremental adjustments when needed to ensure proper structure is maintained throughout.


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