PORTFOLIO BUILDING: Just keep it simple by Ron Copley, Ph.D, CFA, LOL contributing writer

Constructing a portfolio can be as simple or as complicated as one wants to make it. Having built portfolios for hundreds of investors over the past several decades, I believe the simple approach is much better. A well-constructed portfolio need not involve exotic securities, derivatives, or a complicated tax strategy. A basic plain vanilla portfolio is fine. In fact, the simpler, the better. Even an inexperienced investor can construct an efficient portfolio by following a few basic principles. Efficiency here means achieving the highest return possible for any level of risk.
Identifying an Objective. The first principle is to clearly identify an objective, and commit it to writing. Writing has a way of cleaning the thought process. It is an effective way of capturing thoughts based on intellect rather than emotion. Later, when markets are in turmoil, emotion has a way of undermining intellect that usually leads to irrational decisions. The best way of not letting emotions creep into the decision-making process is to commit to a specific objective in a disciplined manner regardless of market turbulence. The written word is a step in the right direction.
Recognizing Uniqueness. A second principle is to recognize that a specific portfolio, no matter how carefully constructed, only fits the needs of the person for whom it was constructed, and no one else. This uniqueness comes from every person’s having a unique personality and a unique set of circumstances surrounding his or her life. It only makes sense, therefore, that each person has a unique objective that leads to a uniquely constructed portfolio. Factors such as age, health, family situation, and financial status drive composition of a portfolio. None of us face the same set of life circumstances, so none of us can have the same investment objective and, hence, the same portfolio.
The uniqueness factor makes constructing a portfolio for the masses an impossible task, which is a major drawback when investing in a mutual fund. A mutual fund may generally appeal to an average investor, but it cannot address the specific needs of an individual investor. Investing in a mutual fund means relinquishing control of important decisions such as what to buy or sell, treatment of capital gains or losses, and recognition of distinctive aspects that make up an individual’s risk tolerance. Mutual fund managers can only guess when addressing these issues. The proper way of constructing a portfolio begins with an investor conducting a needs assessment and ends with selection of securities that fit those needs, not the other way round.
Applying Diversification. A third basic principle involves the appropriate level of diversification. Here again, there is no one answer. Most portfolios should be diversified, but not all. It depends on the level of risk one is willing and able to assume. A time-tested blueprint is to think of a portfolio as a triangle. The base of the triangle comprises securities diversified across multiple asset classes and within each asset class. Base securities provide funds for meeting essential needs of food, shelter, and clothing. At the top of the triangle, some investors may want to allocate a relatively small percentage of funds to a non-diversified, high-risk component. This top component comprises funds invested in securities the investor can afford to lose. If a loss occurs, it will not affect his or her lifestyle or that of his or her family. Construction of the triangle requires a holistic understanding of one’s entire financial picture.
Chasing the Market. A final principle is to avoid the temptation to chase the market. Many investors approach their plan focusing on return as opposed to understanding their risk tolerance. Such an approach is a recipe for disaster. Two forces drive construction of a portfolio: (1) investor needs and (2) market securities. Our job at Copley Investment Management is to bring together these two entities. Our training is deep in understanding the securities markets and we use this training for selecting securities that meet an investor’s specific needs. Our business model is easy to understand and avoids a host of complications that serve the best interest of the adviser at the expense of the investor.
Portfolio construction should only involve publicly traded securities on national exchanges where transactions are completely transparent. Using a reputable financial institution as custodian that provides online access 24/7 is a must. Once a portfolio is constructed, discipline is required to periodically rebalance it back to the intended asset allocation that reflects the desired level of risk. Rebalancing should occur no more than quarterly.
Conclusion. Principles outlined here are not complicated and contain a high degree of common sense. Every portfolio should employ these basic principles with discipline in a consistent manner. A qualified financial adviser can assist for more complicated matters, but most investors can handle the task themselves. It is not rocket science. Keep it simple! LOL
Ron Copley is principal of Copley Investment Management, a Registered Investment Adviser in Wilmington. Besides managing money for individuals, retirement plans, and foundations, he conducts business valuations for the legal community and teaches part-time at UNCW.