Implementing our strategy of portfolio construction requires us to maintain our focus and commitment to our clients and their goals. Particularly important for wealth preservation and tax mitigation is portfolio construction.
At Iron Logic, this translates into four imperatives for perpetual portfolio planning:
Stocks, Bonds, Cash - Asset class composition typically has the largest impact on the risk characteristics of a portfolio. Historically, a higher proportion of equities has typically resulted in more risk and higher returns over the long-term. But, placing all assets in fixed income does not necessarily minimize risk, because rising interest rates cause the prices of bonds to fall (but not necessarily equities). Accordingly, risk could be better managed by combining debt, equity, other asset classes, and investment philosophies.
“There are five common risk factors in the returns of stocks and bonds. Three stock-market factors: an overall market factor and factors related to firm size and book-to market equity. And two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates (junk), the bond market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.” (Journal of Financial Economics, 1993, Fama, French, University of Chicago)
Large Cap Growth/Value, Mid Cap Growth/Value, Small Cap Growth/Value - Equity style diversification is important because the returns of large versus small cap stocks and growth versus value stocks can vary dramatically over market cycles. To their detriment, many investors incorrectly believe the S&P 500 provides equity style diversification. The S&P 500 consists entirely of large cap stocks – no mid cap and no small cap.
“Studies show that U.S. individual investors hold under-diversified portfolios. The level of under-diversification is also correlated with investment choices that are consistent with over-confidence, trend following behavior, and local bias. In contrast, there is little evidence that portfolio size or transaction costs constrain diversification. Under-diversification is costly to most investors.” (Equity Portfolio Diversification in Review of Finance, 2008)
In other recent studies, investors who fail to diversify across equity styles take unnecessary risk for lower returns. “We show an optimized three-style portfolio that omits one co-integrated style, improves performance and lowers market risk, demonstrating the importance of allocation and style diversification.” (Institutional flows and equity style diversification in Applied Financial Economics, 2008, Galloa, Swanson, Phengpis)
Americas, Asia, Europe - Geographic regions’ financial market prices rise and fall in value with the political winds, investors’ expectations, currency fluctuations, and commodity prices. Because most of our investors will spend the majority of their money in U.S. dollars and because historically the U.S. economy has been and is still strong and competitive, large percentages of investors’ portfolios are often kept in U.S.-based investments. Foreign markets are used to help increase risk-adjusted returns through diversification. Unfortunately, most investors are geographically under-diversified.
“Since the fortunes of different nations do not always move together, investors can diversify their portfolios by holding assets in several countries. The benefits of international diversification have been recognized for decades. In spite of this, most investors hold nearly all of their wealth in domestic assets. In this paper we use a simple model of investor preferences and behavior to show that current portfolio patterns imply that investors in each nation expect returns in their domestic equity market to be several hundred basis points higher than returns in other markets. The lack of diversification appears to be the result of investor choices, rather than institutional constraints.” (Investor Diversification and International Equity Markets, The American Economic Review, Papers and Proceedings, 1991, French, Poterba)
Strategic, Tactical, and Other Alternative Strategies – Investment philosophies are a contentious issue in the financial services industry. The battle continues to rage between professionals who trust in strategic asset allocation versus those who believe in tactical money management. When intelligent, well meaning, educated people disagree, there is a possibility that each is correct. The humble and wise conclusion is that during certain periods strategic will outperform tactical and at other times tactical will outperform strategic. Without being 100% percent certain, then, it would be irresponsible to put all of investors’ eggs exclusively in either of these philosophical baskets. Accordingly, we facilitate access to both investment philosophies in a single account, integrated into a single plan.
- Strategic – is a portfolio management strategy in which asset category weights are periodically re-balanced to the target long-term asset allocation.
- Tactical – is an active portfolio management strategy that targets the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors.
Diversifying across investment philosophies is a prudent approach designed to increase risk-adjusted returns.
Simply stated, alpha is considered to represent the value that a portfolio manager adds to or subtracts from a fund's return. In our case, we use this term to represent the value that we, as true wealth managers, add to our client's overall portfolio. Here are two more key ingredients to Our Process:
- Tax Lot Harvesting: This allows our clients to minimize their investment taxes by reducing short term capital gains. We accomplish this by selling shares that they have owned for at least a year before selling shares they have owned less than a year. This pattern of selling is tax savvy, because long-term capital gains rates tend to be substantially lower than short-term capital gains rates. This is one of the single most important tools for reducing investment taxes now and in the future.
- Ongoing Monitoring: The markets are certain to change. We vigilantly maintain the match between our clients’ objectives and their investments (target allocation vs. current allocation) while faithfully taking into consideration the taxes and transaction costs associated with trading. We rebalance our client’s portfolios only when changes in their life situation or the markets make it advisable.