When I went to MDRT in Philadelphia two years ago, Darcy wanted to surprise me by completely renovating our on-suite bathroom (which desperately needed it). He did a fantastic job, removing walls and adding all new fixtures. He even chose the exact color I wanted. We have a solid house, but an older house, which means we’ve spend the last four and a half years picking away at one room at a time. This year’s project is the exterior. We’ve already ordered to doors, so while we’re waiting for those to come in, I decided to start mudding and taping some of the drywall in the laundry room.
This week’s column is going to be the second in a four part series on my investment philosophy. I want to share it with you through a top-down perspective. Last week’s column was about establishing a goals-based approach. Goal: I want walls in my laundry room. I want them to be able to support cupboards of some kind, and I want them to be green. Only by defining my goals can I measure my success. This week will be about setting controls to manage risk. Parameters: How far apart do the studs go? Where does the vapor barrier go? Should we tie a sprinkler in above the dryer? Setting parameters for each of these questions will control some kind of risk – be it fire hazard, water damage, or a structural concern – which will make using the space on an ongoing basis much more enjoyable.
Be it in life or in investing, the greatest risk of poor emotional decision making happens during extreme highs or extreme lows. Last week we looks at using a strategic asset allocation to ensure your portfolio is serving your goals. Luckily, when markets are either really high or really low and the risk for poor decision making is high, this is also the same circumstances that typically cause an asset allocation to move offside. Therefore, it makes sense that we would need to establish and define rebalancing parameters letting us know that it’s time to make a portfolio adjustment long before an emotional reaction occurs. For as long as your goals remain unchanged, your investing parameters will be your best unemotional, unbiased, and personalized investment guide.
Target strategic asset allocation is a measure of upside potential – setting a target allocation to equities in order to spur sufficient growth to meet your goals. Rebalancing can help control the emotional impact of market corrections, however statistics suggest that once a market loses more than 10% of its value, the losses are no longer just limited to that market. This means that after a 10% market correction, geographic diversification becomes significantly less effective.
So, instead of only relying on asset allocation to control downside risk, we protect against these “black turkey” market dips by measuring and monitoring a portfolio’s Value At Risk. Value At Risk is measured by setting aside geography and breaking down an investment portfolio into purpose-based subcategories such as tactical, growth, stability, defensive, and liquidity. These categories are then shock-tested with an extreme 2008-style scenario to determine if the impact is within a range the investor could comfortably withstand.
One of my page-a-day calendars from earlier this year said “Plans don’t fail during the bad times, they fail during the good times - we just don’t find out about it until the bad times.” I fully agree. If you measure and rebalance your Value at Risk during the good times, you won’t have to find out that your plan failed during the bad times.
Once we integrate Strategic Asset Allocation and Value at Risk, we can start refining down to individual holdings. In order to maintain portfolio agility while ensuring there are sufficient structures in place for short term needs, we need to establish a target number of investments. Like the studs in a wall, too many can make for a complicated, time consuming, and expensive mess, but too few may not give your portfolio the structural integrity it needs to carry the load of a changing market. There can be some flexibility here – it’s the least strict of my usual parameters – but it’s important to always be mindful of what you’ve got going on. You don’t want to oversimplify, and you don’t want to create a mess.
Once we have an idea of how many holdings are ideal for a portfolio, we need to make sure they are all unique holdings, not duplicates of each other. Correlation is a measure of how similar investments are in both the direction and extent of how they react to market stimuli. I’m flexible when it comes to the number of holdings in a portfolio, but I’m not really flexible at all when it comes to correlation. If we allow correlation to creep up too high, then all holdings in a portfolio will go up at the same time. And if they all can go up at the same time, the all can go down at the same time. The purpose of correlation is to maintain unique and distinct holdings so that extreme highs and extreme lows can cancel each other out. By setting and monitoring a parameter for correlation, you can ensure that each holding is complimentary to the team, which significantly reduces a portfolio’s overall short-term volatility.
And finally, once you have your customized goals-based portfolio with a suitable asset allocation, Value at Risk, number of holdings, and correlation, it’s time for a quick review to make sure that the concentration of each holding is in line. There are two main issues here. The first one is making sure each holding is significant enough to make a meaningful impact on your portfolio. The second issue is making sure any holdings aren’t over-concentrated.
Minimum and maximum concentration risk parameters vary, to some extent, depending e on the target holding period of that specific holding. Typically, long-term core holdings have higher minimums and maximums than shorter-term tactical holdings.
Once you have you goals established and you know what the end result is, it’s important to build parameters that incorporate the long-term enjoyment of the space. The walls should be strong, straight, and not riddled with electrical outlets. Just the same, your portfolio should be focused, efficient, and meaningful. Three ironing boards won’t do me any good (I probably still wouldn’t put them away), and each holding in your portfolio should have a distinct purpose and have different functionality than everything else.
Start with goals-based planning, and then establish parameters to control downside risk and make portfolio management easier. Done properly, you can look forward to a more comfortable, efficient, and meaningful investing experience.
For more information on establishing parameters for your portfolio, or for more information on establishing an investment philosophy, speak with a CERTIFIED FINANCIAL PLANNER© today.
Written by Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER®
Advantage Insurance & Investment Advisors
Investment Funds Representative
Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.