By Ben Carlson, A Wealth of Common Sense
“I will not abandon a previous approach whose logic I understand even though it may mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.” – Warren Buffett
One of the questions I’m often asked is to review someone’s current asset allocation and make recommendations about any changes or updates that are needed. I always say that this is an impossible task without an understanding of the person’s entire financial picture, risk profile, time horizon and goals.
Plus there’s the fact that the perfect portfolio can only be known with the benefit of hindsight. At a certain point, making minor tweaks and changes to your asset allocation won’t have that much of an impact on your performance. Your ability to stick with your chosen asset allocation will. Without being able to give specific asset allocation advice to everyone that asks, here are some intangible risk controls to consider when constructing a portfolio:
Understand what you own. This seems obvious, but you’d be surprised at the number of investors (both average and professional) that have no idea what their underlying funds even own or what purpose their holdings serve. One of the most important forms of risk management is a true understanding of everything that’s in your portfolio from top to bottom. You should have a good idea about the liquidty constraints, total fees, historical loss profile, long-term performance characteristics and potential risks of each asset in your portfolio. Knowing all of this doesn’t mean there won’t be unexpected events in the future, but it will soften the blow so you’re not totally taken by surprise every time some turbulance hits.
Know why you own it. Every single security, fund or asset class should have a reason for inclusion in your portfolio. Most portfolios are a mish-mash of different funds or securities picked up throughout the years with no ryhme or reason from one to the next. Investors assume holding a large number of funds means they’re diversified without actually thinking through how the individual parts work within the construct of an overall portfolio and investment plan. Having a legitimate reason for inclusion in a portfolio makes it easier to manage and cuts down on the potential for over-diversification or unecessary complexity.
Set reasonable expectations. I’m a fan of setting return expectations on the low side. This forces you to save more and be surprised on the upside if things turn out better than expected. There’s no downside to lowballing your expected returns for each asset class. Setting sky high expectations rarely ends well.
Know yourself. Your mix of assets has to strike a balance between your desire for comfort now and your desire for comfort in the future. This includes taking into account your own personality — your biases, quirks, natural tendencies and how you react under pressure. You can’t force yourself to adopt a certain portfolio type if it’s not something you’ll ever be comfortable with.
Will you continue to make good long-term decisions even if you’re unhappy about short-term performance? Your chosen asset allocation at any given point in time should be a reflection of an evidence-based, long-term process. At times, it will feel like you’re making all of the wrong decisions based on current market performance. But you can’t let the markets dictate how you feel about your portfolio at every turn. You’ll never be satisfied that way because there will always be a move you wish you would have made after seeing how things play out.
That means once you make your choice you have to be able to stay the course even when you aren’t pleased with every single result. It’s very difficult to consistently think process over outcome when you’re not always happy with the movements of the markets, but that’s the only way long-term strategies work.