Practical analysis for investment professionals
15 July 2014

Designing Portfolios: Seven Key Investment Principles to Help Keep Clients on Track

You’ve no doubt heard the famous aphorism that “the market can stay irrational longer than you can stay solvent.” The saying may be well worn but it nonetheless serves as a useful call to action — especially when US markets are soaring to new highs and investors’ emotions are apt to be driving portfolio management decisions.

You know how it goes: “The market is going up! My portfolio is up! Buy more! Now!” But how will it end?

A recent Wall Street Journal article puts the current buying frenzy into context. “As the stock market surges to new highs, ordinary investors who missed a lot of the gains have been rushing to jump on board,” the Journal reports. “So far this year, they’ve poured $58 billion into stocks via mutual funds, according to the Investment Company Institute. That’s the biggest first half for mutual funds since the last big boom, in 2007.”

At a recent wealth management conference hosted by CFA Society TorontoRon Florance, CFA, included the quote in a slide reminding investors that it’s important to know how much liquidity they need in order to stick with their long-term investment plans. “Clients’ emotions swing from greed to fear to hysteria to elation,” said the former deputy chief investment officer for investment strategy at Wells Fargo. “They can derail themselves pretty rapidly.”

At the conference, Florance outlined several principles that should be part of every investment plan. “The seven key investment principles help us to steer [client] conversations so that we are keeping people from making short-term, emotional decisions,” he said.

1. Know your “number.”

How much cash should you have sitting around?

“What we find is that during times of greed, there is no cash sitting around because everything is invested,” Florance said. “And then during times of fear, it is exactly the opposite, just massive, massive amounts of cash sitting there.”

So the question to put to your clients is: How much money do you need sitting around so you can sleep well at night? Is it six months’ living expenses? Is it 12 months’ living expenses? Is it an actual number — a million dollars, or maybe $100,000?

“What is that number so that when you wake up in the middle of the night panicked, you are not panicked about money. You can pay the bills. Generally if it is between six and 18 months’ of living expenses, that’s pretty realistic.”

The take-away: This number is the level of liquidity that your client needs to stick with his or her long-term investment plan.

2. Knowing your time horizon makes all the difference.

People seem to forget this during times of fear and greed, Florance said. It goes back to the question: What is the money for? This matters, because the answer will inform the investment strategy. For example, if you are planning on spending the money in a few days, then putting it in a checking account is fine. But if you are going to spend it over the next few years to fund a business opportunity, you need a different investment plan. Similarly, if you are going to spend it over the next seven years to pay for a college education, that requires yet another investment plan. If it will be spent over the next 25 years to fund retirement, this is a different need. So asking your client “What is the money for?” is really important.

“During times of fear, time horizons get incredibly short. [Investors say] ‘Did you see what happened to the stock market today? My portfolio went down!’ And during times of greed it’s exactly the opposite,” Florance said. “The time horizon is incredibly important. What’s the money for? Make sure the duration of the liability matches the duration of the asset.”

The take-away: Uncertainty about returns generally diminishes over time.

3. Managing your clients’ financial goals and strategy is an on ongoing process.

Strategic asset allocation is the most important decision. It should be long term, but not static.

“Strategic asset allocation isn’t stagnant… it’s evolving because of life circumstances, because of financial needs, because of desires; not because of what somebody said on television, or radio, or in a blog,” Florance said.

The take-away: Long-term asset allocation is the dominant driver of a portfolio’s return variability. Thus you need to update it regularly to align it with changes in your clients’ personal circumstances.

4. Aim for consistent returns through diversification.

Standard deviation “is not just a mathematical exercise. The reality is volatility. The path you take does matter,” said Florance. “If you lose 50% of your assets, you don’t need to earn 50% to get back to even. You need to earn 100% to get back to even. So those down drafts are incredibly painful.”

When we talk about standard deviation and diversification, there is a reason for it, he added. “Because at the end of the day, it means you end up with more money. Not all returns are created equal. The path is very, very important. It’s not just about standard deviation… at the end of the period, are you ending up with more money because the path you took was much smoother?”

The take-away: Smooth and steady performance often wins the race.

5. Risk is far more than volatility.

Pop quiz: How do your clients talks about risk? Annualized standard deviation? Losing money? Not meeting a net worth goal? Underperforming the neighbor’s portfolio? Missing out on an opportunity?

Many clients think of risk as “losing money” but that’s not how the industry talks about it: the industry talks about “annualized standard deviation.” So there is a disconnect.

“I’ve never once met a client who came in and said: ‘You know, our money is managed at [XYZ firm] and we have 17.5% annualized standard deviation. If you can get that down to 14.25% we would be a lot better off’,” Florance quipped. “But that’s exactly what we design.”

Florance said advisers have to rethink: What is risk? The financial crisis really highlighted that risk isn’t just about annualized standard deviation or volatility. There are lots of different risks.

In today’s world, where investors own many different asset classes, it’s important to understand the different types of risk that clients are exposed to. For example: structural risks (operational, concentration, leverage, liquidity, transparency); style/strategy risks (event, performance volatility); and systematic risks (commodity market sensitivity, bond market sensitivity, equity market sensitivity).

These are the risks that investment professionals have to pay attention to, but, broadly speaking, the risks that clients listen to are things like the risk of losing money, the risk of not having enough money, the risk of “missing out,” and the risk of personal or family security, according to Florance.

It’s important for advisers to translate market, investment, and capital market risks into risks that are tangible for clients, and everyone is different, he added.

The take-away: Risk comes in many forms and client-oriented risk perspectives differ from the way in which the industry talks about risk. 

6. Discipline and process trump emotion.

This observation is especially vital for investment professionals working with private clients.

“A lot of [wealthy] clients confuse self worth and net worth. We have to be able to pull those two things apart. Your net worth does not determine your self-worth but clients don’t see that difference and that emotion is just enormous,” Florance observed.

He added that it is important for advisers to segregate what is prudent from what is emotional when clients ask for changes to their portfolios.

“Rebalancing is the discipline of selling risk when it is expensive and buying risk when it is cheap,” Florance said. “That is a good investment strategy. The problem is that you have to sell your winners and buy your losers. And that feels awkward… So that discipline of rebalancing is critically important… As you go through a market cycle, basically what happens if you don’t re-balance is you are underweight risk at a market bottom and overweight risk at a market top — and it’s exactly the opposite of what you need to do. Rebalancing fixes that problem.”

The take-away: Rebalancing, as Florance puts it, “is the discipline that helps us pull emotion out of the portfolios.”

7. You are a global consumer, be a global investor.

Home-country bias is incredibly strong — and investors in North America are among the worst offenders, Florance said. Ask yourself (and your clients): If you are really a global consumer, why aren’t you a global investor?

The take-away: By only focusing on the domestic market, your clients may forgo a chance for diversification and growth opportunities. (See: Pros And Cons Of International Diversification).

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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About the Author(s)
Lauren Foster

Lauren Foster was a content director on the professional learning team at CFA Institute and host of the Take 15 Podcast. She is the former managing editor of Enterprising Investor and co-lead of CFA Institute’s Women in Investment Management initiative. Lauren spent nearly a decade on staff at the Financial Times as a reporter and editor based in the New York bureau, followed by freelance writing for Barron’s and the FT. Lauren holds a BA in political science from the University of Cape Town, and an MS in journalism from Columbia University.

5 thoughts on “Designing Portfolios: Seven Key Investment Principles to Help Keep Clients on Track”

  1. Jamal Munshi says:

    Great article. Historical standard deviation is important of course but don’t you guys also do a forecast standard deviation? Here is an example of a forecast standard deviation estimation. Current price = $10. Suppose there are three forecast states of the market next period – state#1 – probability = 20%, price=$13, returns = 30%, state#2 – probability = 30%, price=$12, returns = 20%, state#3 – probability = 50%, price = $9, returns=-10%. Forecast returns = 0.2*0.3+0.3*0.2-0.5*0.1 = 0.06+0.06-0.05 = 0.07 = 7%, variance = 0.2*(0.07-0.06)^2 + 0.3*(0.07-0.06)^2+0.5*(0.07-0.05)^2 = 0.00025 and so the standard deviation is the square root of 0.00025 = 0.0158 = 1.58 percentage points which means that the 95% confidence interval of expected returns = 0.07-1.96*0.0158 to 0.07+1.96*0.0158 = or approx 4% to 10%. Hope I got the numbers right.

    1. Dan says:

      What is your basis for the probability figures used in the calculation? I can’t seem to figure out what the proper probability should be for, say, state #1 or understand how you came to the conclusion that it should be 20%.

  2. John Butters says:

    “For example: structural risks (operational, concentration, leverage, liquidity, transparency); style/strategy risks (event, performance volatility); and systematic risks (commodity market sensitivity, bond market sensitivity, equity market sensitivity).”

    I agree that risk is more than SD. But your structural risks can be minimised almost without thinking by a sensible portfolio-construction methodology (liquidity requirements, concentration limits, no leverage, etc.). Systematic risks can be summarised by the standard deviation of portfolios. I have done some work on the relationships between SD, VaR, maximum drawdown and other measures of risk (but not “permanent capital loss”; the risk of “permanent capital loss” is minimal in a diversified portfolio, unless the Martians invade). Basically, all these risks are highly correlated in back-tests of randomly-generated portfolio allocations. So, a lot of the time, SD is a good proxy for risk.

  3. Lauren,

    Thank you! Great article, I really enjoyed it. On the second point, I can’t agree more that properly defining the real purpose of the investment and the time horizon are critical elements of developing the right investment strategy.

    However, I’m wary about the language in the #2 take-away which reads, “Uncertainty about returns generally diminishes over time” because many people are still led to believe that somehow risk is reduced over long time periods or that they will automatically earn an “expected” rate of return over a longer time horizon.

    As a point of fact, the standard deviation of returns actually increases by the square root of time. For example, if the time horizon is 25 years then the standard deviation of returns (risk) over the period is (√25 years =) 5 times wider than the one-year standard deviation of returns. So, the risks to wealth accumulate with time and markets can and will fail to meet “expected” return assumptions.


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