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Can an Investor Attain a Perfect Portfolio? Thumbnail

Can an Investor Attain a Perfect Portfolio?

Charles Verruggio Discovery Financial Planning Investment Management

Investors pursuing the “perfect portfolio” is an age-old endeavor. Obtaining the perfect portfolio is like attaining perfect health—there really is no such thing. You can embrace behaviors to maximize your health such as exercising, eating right, getting plenty of sleep, drinking a lot of water, staying away from toxins, etc. However, someone who engaged in every healthy behavior possible would still be hard-pressed to say they were in perfect health. 

In their book In Pursuit of the Perfect Portfolio, Andrew Lo and Stephen Foerster point out that the same applies to the concept of the perfect portfolio. There are plenty of behaviors and techniques you can use in order to put yourself in the best position to obtain strong risk-adjusted returns, however, achieving perfection? That’s a different story.

The other aspect of the analogy that applies is that attaining both perfect health and the perfect portfolio is a very individual exercise. In each case, what is optimal for one person, say, a 22-year-old fresh college graduate, is usually not what is optimal for another, say, a 72-year-old retiree. As we see it, both optimal health outcomes and optimal portfolio outcomes are best achieved on an individual basis.

Further, there is not just one way to be healthy. There are multiple combinations of diet, exercise, sleep, and mental and spiritual health that could lead one to a very positive health outcome. The same applies to portfolio management.

Internally, at Wolf Group Capital Advisors, when we contemplate what makes the best possible portfolio for each of our clients, we envision a portfolio that allows each client to feel comfortable regardless of the type of market environment that exists. If a client feels the need to sell out of their portfolio when the market drops by 2-3% in a week, that would signal to us the portfolio they own is too risky for their preferences and the asset mix may need to be altered to something a bit more conservative. Conversely, if their benchmark has provided a return of 8% and they have achieved a return of 9% and they are still frustrated with their returns, that can be a signal they would feel comfortable having a bit more risk in their portfolio.

When it comes to optimal portfolio management, there are plenty of books written on the subject, most of them quite academic in style. While I’ve read numerous books of that nature, I continued to pursue something more practical and that is when I came across Andrew Lo and Stephen Foerster’s book In Pursuit of the Perfect Portfolio. This book outlined how ten giants in the world of portfolio management (Harry Markowitz, William Sharpe, Eugene Fama and Myron Scholes to name a few) would design their optimal portfolio.

Given the inherent complexities and the endless nuance of investment management, there is no surprise that consensus was not reached. There were, however, some themes that emerged. Some of those themes present in multiple practitioners were:

  • Diversification is key to constructing the perfect portfolio
  • Asset allocation is typically the primary driver of returns, not individual security selection
  • Investors should aim for the highest level of return for a given level of risk
  • Ignore short-term noise
  • Your asset allocation should change over time as do your life circumstances and as market environments evolve
  • An investor’s focus should be on after-tax returns
  • Be prepared to adjust if you are in danger of missing your goals
    1. Save more
    2. Spend less
    3. Work longer
  • Avoid overconfidence and keep emotions in check
  • Your perfect portfolio should depend on who you are
    1. Your age
    2. Your dependents
    3. Your spending habits
    4. Your assets
    5. Your comfort with risks
    6. Your access to information
  • Remember that investing is all about you
    1. Your values
    2. Your history
    3. Your perfect portfolio is the portfolio that will best help you reach your goals

The authors go on to point out that each of our perfect portfolios is a moving target. One that depends on who you are and where you are in your career and life. It also depends on how favorable or hostile the current market conditions are to your short-term and long-term goals. Lo and Foerster are so kind as to give the reader principles to follow to assist in achieving the perfect portfolio. Those seven principles are:

  • Principle #1 = Determine how much expertise you have in financial planning and how much time and energy you’re willing to devote to managing your perfect portfolio
    1. This will help determine if you are willing and able to manage things on your own.
  • Principle #2 = Determine what your current and future financial needs are
    1. This isn’t easy and requires deep personal reflection and a significant time commitment as well as regular reviews and some financial expertise.
  • Principle #3 = Find your comfort zone regarding financial gains and losses
    1. How much can you lose before you make the decision to move to a less risky portfolio stance?
  • Principle #4 = Think about your investment philosophy and what you believe about markets and be prepared to update it along the way
    1. Principle #5 = List all the assets you have and all the assets you are willing to hold
      1. This is your menu of options
    2. Principle #6 = Develop a sense of the current investment environment and how stable that environment appears to be, relative to historical norms
      1. Manage the risk of your perfect portfolio so that you’re exposed only to risks you’re comfortable bearing.
      2. Maximally diversify across investments that carry the highest possible premium relative to their risk.
      3. Be comfortable monitoring your investments on a regular basis, especially as markets and your own personal circumstances change over time.
    3. Principle #7 = Avoid obvious investing mistakes
      1. Experiencing high and costly turnover in your portfolio
      2. Needlessly incurring taxes
      3. Borrowing to invest without enough capital in reserve
      4. Understand that people don’t always act rationally

    Lo and Foerster go on to point out that the list seems complex because it is! And this complexity is exactly how 10 investing experts end up with 10 different perfect portfolios. None will be right all the time for all investors.

    In summary, while the perfect portfolio may not exist, one can invest in the best possible portfolio for their specific set of circumstances. The pursuit of this portfolio is an ever-evolving challenge that takes place amidst constantly fluctuating variables. These variables include but are not limited to your income, your spending, the prevailing market environment, your current assets, your current liabilities, your age, your family situation, your propensity to leave assets to the next generation, your investment vehicle preferences, your return expectations and your ability to deal with various levels of market fluctuations.

    I’ll leave you with the following observation that Lo and Foerster make in the last few paragraphs of their book, “there is an old Zen saying that you can never step in the same river twice. Perhaps you can never have the same perfect portfolio twice…if you’re adapting as frequently as you should. And keep in mind, whichever river you step into, you’re going to get wet.”

    Sincerely,

    Charles Verruggio

    Chief Investment Officer

    About Wolf Group Capital Advisors

    At Wolf Group Capital Advisors, a comprehensive wealth management firm and Registered Investment Advisor (RIA) based in Fairfax, VA, nothing is more important than the fiduciary responsibility we have in managing your wealth. Taking the utmost care, we focus on providing advice tailored to your specific circumstances. With more than two decades advising U.S. expatriates and non-US citizens employed by international organizations, we are qualified in investment strategies addressing global issues. Empathy and curiosity—combined with our experience in life planning and investment management—enable you to explore a wider set of possibilities that can lead to a fulfilling life you’ve worked hard to attain.

    Disclosure:

    The information presented is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice.

    Diversification and asset allocation do not ensure a profit or guarantee against loss.

    Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website. Past performance is not a guarantee of future results.