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Financial Planning and the Policy Portfolio

Our Philosophy and Method of Operation

Financial Planning

Financial planning is the important first step in this part of your financial journey. It is used to figure out exactly what you want to do and the most efficient ways to approach whatever that is. Only after you and we figure out the direction you need to go, can we begin designing investment portfolios.

Financial Planning is the phrase we use to discuss everything having to do with your finances. Unfortunately, the term has acquired some negative connotations because of the "plan salesmen" who sell plans by the pound sending you home with a fat invoice and a 300-page document that is out of date before you read the first page and is usually never looked at again.

We believe financial planning is a never-ending process that cannot be captured in a document stored in a ring binder. We believe it consists of the questions that come up about financing the next car or the mortgage or planning for retirement or college funding or any of the myriad other financial questions that pop up daily.

Financial Planning is an integral and continuing part of the service we offer our clients.

Policy Portfolio

Example - Pattern - Archetype - Standard - Prototype - Model

These are other words that can be used to describe what we refer to as a Policy Portfolio. Our Policy Portfolio is the starting point we use to guide us when we design clients' portfolios. Such a portfolio rests squarely on one premise, life is uncertain. We cannot know the future, but we have to prepare to live in it. Also, while we cannot predict the future we do know about the past and can learn from it. Consequently, our Policy Portfolio is based firmly on what we know has already happened and what that implies for the future. This basic portfolio allocation has proved to have a very good balance between risk and return. However, we also realize that because the financial markets have behaved in certain ways for the past 150+ years does not mean they will behave similarly in the future. There are so many more types of investments today that did not exist even a few years ago that the entire investment palette has changed dramatically. We cannot continue to paint the same investment picture as in the past.

One concept we stress with our clients is the difference between investments and investing. Investments are the individual components or puzzle pieces – each but a part of something larger than itself. No one can control or modify the risk/return characteristics of a single investment, but when you combine different investments into a well designed portfolio, you can, indeed, affect the risk/return characteristics of the portfolio. That is investing.

Most people would logically describe a “good” investment as one that grows in value and a “bad” investment as one that declines in value. Actually, we think of good and bad investments in terms of predictability. A “good” investment is one that does what we expect it to do and a “bad” investment is one that surprises us by its actions. As we stated previously, we cannot control the risk/return characteristics or behavior of any single investment, but we can design and assemble a portfolio that is predictable. “Predictable” allows you to sleep better.

While we may not agree with every word printed, here is a short book that explains investing concepts very similarly to the way we think.
Buy it:
From Books-a-Million
From Barnes & Noble
From Amazon

One insightful writer has compared investing and portfolios to food — one of my favorite subjects. He says that people have historically thought of their investments as you would a salad and creating an investment “portfolio” was like adding different vegetables to the salad bowl. While it may be an enticing mixture of ingredients, each vegetable — and each investment — is still uniquely identifiable and continues to maintain its own identity, function and “flavor.” The raw ingredients may be sub-divided into different classes — stocks can be divided into domestic vs. foreign, small vs. large, value vs. growth — but dividing a carrot for the salad into 6 or 12 different slices does not transform it into something new or different; it is still a carrot. Salads are good. Mixtures of investments may be good, but such a mixture does not necessarily make a portfolio.

Now, let’s think of soup. When you combine the raw ingredients to make soup, you anticipate that the resulting concoction will be uniquely different from the ingredients that go into making it. The finished product is not just the sum of its components; it is a different product. The raw ingredients have been transformed into something new and different — the soup. Such is the case when designing an investment portfolio. A well designed portfolio is much more than just the mathematical sum of its component investments. The resulting portfolio has unique characteristics of risk and return that are different from any of its component investments. The portfolio is a new and different investment designed to allow the specific client’s pursuit of financial needs and goals. One should not look inside the portfolio to determine which of the component investments will provide income or growth or risk aversion. The investments are no longer as important as the portfolio. The whole is indeed, larger and more important than the sum of its parts.Fundamental Allocation

Listen to an audio discussion about portfolios.

Our Policy Portfolio includes three components, Growth, Moderation and Opportunistic assets. The most important decision you and we make is the most fundamental; what portion of your portfolio should be in Growth and what portion in Moderation. Opportunities or Special Situations will take care of themselves.

Growth assets are those assets that offer exposure to traditional financial equity and equity-like markets; that is, you seek exposure to growth markets with no real attempt to "beat" those markets. Instead, you accept market returns and take only market risk. The most efficient way to gain this growth market exposure is through the use of low-cost closed-end exchange traded funds or index-funds that invest in the indexes we seek to emulate. The allocation to Growth assets will be within the range of 20% to 80% of the total.

Active Management vs. Passive Investments

Predicting the future is hard.
Predicting someone else's ability to predict the future is really hard.

Within that Growth allocation, a portion is allocated to to equity assets (stocks) and a portion is allocated to real assets (real estate, commodities and natural resources). When situations warrant, a portion of the equity-like portfolio may be allocated to high yield and emerging markets bonds.

Allocation to equity market exposure — common stocks — will be within the range of 10% to 90% of the Growth portion of the portfolio. Within that stock portion, we will allocate to both domestic and foreign stocks. Depending on the size of the individual portfolio, the equity portions of the portfolio may include small capitalization stocks as well as stocks from emerging economies.

Growth AllocatioinWe think an efficient way to gain this core stock exposure is through low-cost exchange traded funds or index funds. We see no empirical reason to pay the higher fees associated with actively managed mutual funds to acquire this fundamental growth market exposure. By saving the extra fees, you may boost your total return.

Market exposure to real assets is also gained primarily through low-cost exchange traded funds or index funds and should be between 5% and 50% of the Growth portion. We see two basic components of real assets: real estate and commodities/natural resources. Commodities include things such as crude and heating oil, aluminum, gold, wheat and corn. Natural resources include things such as oil and gas, metals and mining, energy equipment and services, containers and packaging, paper and forest products, construction materials and others.

We will determine the allocation to stocks, real estate or commodities according to what we see, hear, read and think about the contemporaneous condition of those markets. We will over and under weight those categories as we see the opportunities either present themselves or subside.

Strategic Asset Allocation - A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation. At the inception of the portfolio, a "policy mix" is established based on expected risk and returns. Because the value of assets change with market conditions, the portfolio needs to be re-adjusted to continue to meet the policy.
           
- Investopedia.com

We have described the Growth portion of your portfolio but that is only a portion of your total portfolio. Now we must add some Moderation to that unconstrained Growth potential. The Moderation portion of your portfolio will be between 80% and 20% of the total portfolio depending on our discussions with you.

Not only are there now many more types of investments available to the investor, but many more strategies are now executable that were virtually impossible a short time ago. Alternative assets and alternative strategies both offer the possibilities to hedge against unexpected movements in various growth markets. Such prevarication may help your portfolio travel a smoother route; allowing your assets to grow while allowing you to sleep better at night.

The Moderation portion of your portfolio will include traditional diversifying assets such as cash and bonds as well as more esoteric assets and strategies including hedging strategies and diversifying assets.

The fixed assets include three basic components: cash and cash equivalents, domestic fixed income securities and foreign fixed income securities. 

Moderation AllocationThe point of using diversifying strategies is to diversify volatility away from the Growth portion of the portfolio. If a particular strategy proves to follow the trend of traditional markets even if it has lower volatility, it may not really serve the function of a diversifying strategy. Sometimes, this higher-than-expected correlation of volatility only shows up when markets are trending downward -- exactly the time we need the diversifying strategy to be uncorrelated. Very few strategies have actually proven that they are both uncorrelated and produce acceptable returns. As we pointed out earlier, we see no proven advantage to using actively managed mutual funds in search of traditional market exposure assets, but we do see value in using some active managers in search of specific alternative strategies.

There are talented asset managers who use attractive strategies and tactics of managing specific types of portfolios. The management focus may be on higher return or lower volatility or seeking to profit from inefficiencies in specific types of trades or markets. We continually research which strategies actually work and which mangers effect the best results so your portfolio volatility can be moderated.

As we said earlier, the fundamental allocation between Growth and Moderation is the most important decision you and we make in designing a portfolio specifically for you. There are several factors to consider when deciding on that proportion including the time you have to let your portfolio work. The longer your time horizon, generally the more you can devote to growth. Conversely, the shorter your time frame, the more certain you must be that the funds will be available when you need them. Also, you must consider your capacity to take risk. As an example, the more guaranteed income you have in retirement, the more "risk" you may be able to take; you have the capacity for risk because your living expenses are met from other sources. Lastly, is your temperament. You may have a great capacity for risk in that you may not need your capital to generate income for living expenses, but you may not have the temperament to sleep well not knowing how your portfolio may perform over the next week or quarter or year. You may have the capacity to take risk but not the willingness to take risk. Others may have the willingness to take risk but do not have the capacity to take it. To ascertain your fundamental portfolio mix, we must discuss at length your time horizon, your capacity to take risk and your ability to accept risk. These questions cannot be answered in a formulaic questionnaire. We spend a goodly amount of time talking and discussing and educating before we make any decisions about how to allocate a portfolio for you.

Lastly, the portion of the total portfolio that interests many people the most is Opportunistic Assets or Special Situations. Here, we seek those assets that have the potential to pay a profit well beyond market returns and usually over a shorter time. These are the “high-flyers” that folks like to brag about at cocktail parties. These are the securities with interesting stories. These are the “fun” things to talk about. They are also the most volatile assets with the greatest potential for loss – up to total loss. We believe that such opportunistic assets deserve a place in the total portfolio, but a relatively small place in the portfolios we manage. Also, this is the "pigeon hole" where we may place your unsellable family company or the apartment building you own with your brother-in-law. We do not have a specific amount of predetermined allocation to the Special Situations area because it is, well, special.

Let’s recapitulate what we have discussed so far. Investment portfolios, as we manage them, should have three major components: Growth assets, Moderation assets and strategies and Special Situations.

  • The Growth portion may be the largest part of the portfolio and is made up of the traditional growth-oriented financial market assets.
  • Moderation assets and strategies include esoteric assets and actively managed accounts we believe will benefit your portfolio by moderating risk.
  • Special Situations may give you the chance to “swing for the fences.”

We’re not finished yet.

Once we have allocated the Growth portion of your portfolio, that is, we have properly invested your strategic asset allocation, we then track the different components of it weekly to ascertain the trends being established by the respective markets. No one can predict what the financial markets are going to do, but with a little bit of insight and a lot of data, one can determine the general tendencies or trends. We look to have your portfolio fully invested most of the business cycle but we also look to sell certain assets or certain categories as their trend begins an apparent downward spiral. We anticipate offering some amount of insulation from future down markets by closely watching the trends of the various components of your market exposure assets and acting accordingly.

Acting accordingly means that on top of your well-designed Growth portfolio, we may overlay the risk management strategy of dynamic asset allocation. Simplistically, when a specific market as represented by the chosen security (either an ETF or index fund as discussed earlier) is trading above its average price for a specific period, we may either buy or hold onto the security for that asset class. When the price of that security drops below its average price, we may sell that security. Selling the security does not indicate that we no longer “like” either that specific security or the asset class it represents. It simply means that our model is indicating that it is in your best interests to be out of that particular asset class at that particular time.

Additionally, we may sometimes use ETFs that perform inversely to their specific market. For example, if U.S. Stocks as measured by the S&P 500 index drop by say, 6%, an inverse ETF may actually increase by 6%. These inverse funds would potentially be used when an asset class as represented by its ETF falls below its average price and requires that we sell that ETF as in the previous paragraph. We would sell that ETF and then consider buying the market inverse ETF to take advantage of falling markets. We anticipate that by using these inverse ETFs we may eek out a bit more positive return in the long run. However, since markets historically have risen more often that they fall, we will be judicious in the use of inverse funds.
Dynamic Asset Allocation - An active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors. This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace. It is a moderately active strategy since managers return to the portfolio's original strategic asset mix when desired short-term profits are achieved.
 - Investopedia.com

While this dynamic asset allocation has the potential to increase the total return of your portfolio over a full cycle, we view it primarily as a risk management technique. Know that during roaring bull markets such as we experienced in the 1990s, your portfolio may not return as much as the overall stock market. However, when the “bubbles” burst, as they always do, your portfolio may very well be spared some of the severe drops in portfolio value or what is known in the industry as “drawdown.” The financial markets have experienced some pretty large drawdowns in the last few years, but because of our attention to risk management, your portfolio has held up reasonably well. Through the application of dynamic asset allocation, we intend to mitigate such losses in the future even more diligently. While no technique will insulate your portfolio from “shock” events such as October 19, 1987, the infamous "Black Monday" when the US stock market lost more than 20% in one day, the intent of implementing this technique is to allow your portfolio to grow along a smoother curve; to increase the statistical predictability of your portfolio; to make the bell curve steeper with fewer fat tails. Call us for more details.

Once you and we have chosen the fundamental relationship of Growth to Moderation, we are free to research the alternative assets, alternative strategies and opportunistic assets that help differentiate FCVA portfolios from other advisors’ who use less diverse and less attentive portfolio allocation strategies. That benefits you; your portfolio is designed to increase the growth of capital and provide income — the only reasons you invest — while offering enough diversifying strategies and tactical risk management to allow you to sleep at night knowing your portfolio is in thoughtful hands.

Please remember, this is discussion is about a model portfolio, not a required portfolio. Virtually every client's portfolio will vary in some way from the standard discussed here but all will have the basic tenants of growth with safety so that you may be more likely to have

what you need, when you need it.

 

FCVA is expanding. We are looking to purchase / merge with an existing RIA that is truely independent from any outside influences or conflicts of interest. We have been offering real client-first, fee-only advice and service since 1985 and would like to offer that service to more folks. Contact us at info@fcva.net to indicate your interest.
No obligation, just discussion.
 

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757 399 7499
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Financial Counselors of VA is an independent Registered Investment Advisor based in Portsmouth, VA, providing
fee-only financial planning services and investment management advice to individuals and families since 1985.
Copyright 2005-2014 by Financial Counselors of Virginia, Inc. All rights reserved.