How to determine the suitability of an investment portfolio?

Many investors’ existing portfolios are not well suited to accomplish their goals.  But how does one determine whether a portfolio is well constructed or poorly constructed?

I have categorized the important elements into five categories.  These broad categories are asset allocation appropriateness, diversification, security selection, investment decision-making process, and tax efficiency.  These categories are not mutually exclusive, due to the subjective nature of the task and the fact that most investment decisions have a wide range of effects and consequences.

1. Asset allocation appropriateness judges whether the top-level asset allocation fits with the particular characteristics of the individual investor.  This takes into account portfolio size, investor age, experience, comfort with risk, level of involvement, knowledge of finance, whether money is being added to or subtracted from the portfolio, significant milestones, and long term goals.  A top-level allocation examines the distribution of assets among major classes of investments, such as stocks, bonds, cash equivalents, real estate, and alternative investments.  It does not delve deeper into these asset classes: that is covered in the next few categories.

2. The next category, diversification, examines how diversified the portfolio is, taking into account its size, goals, etc.  In an uncertain world, diversity is the best defense.  Undiversified portfolios expose investors to higher levels of risk, which are not compensated for by increasing the corresponding chance of success.  When unanticipated events occur, the portfolio is poorly positioned and the investor can suffer as a result.  The more undiversified the portfolio, the higher the level of risk when the unforeseen future arrives.

3. The third category is security selection.  There are several significant sub-components to this measure.  The most important one is costs.  Although it is impossible to eliminate all costs from an investment portfolio, efforts should be made to keep the costs as low as possible.  Fees and expenses paid to middlemen subtract from the portfolio’s return and reduce the amount of money available for future investment and compounding of income and capital appreciation.  A second sub-component is transparency.  It is very clear what you own with some investments, such as the ownership of an individual common stock or bond. It can be difficult to find out exactly what you do own with other types of securities such as actively-traded mutual funds, hedge funds, private equity funds, and “structured investments.”  Not knowing what you own leads to inefficient and poorly managed portfolios, since different types of investments can cancel each other out, or magnify risks well beyond the tolerance of the investor without his or her knowledge.

4. The fourth category is an assessment of the investment decision-making process.  Is the process well-thought out and designed to achieve long term goals when markets are in a constant state of flux?  Or is it akin to gambling, where an investment advisor chooses securities based on predictions of a particular future scenario?  A sub-component of the process evaluation is to measure the quality of the timing aspects of the choice of when various securities were bought and sold.  Even though everyone knows that buying low and selling high is the correct thing to do, many investors end up doing the opposite, since they are driven by numerous psychological urges that lead them astray.

5. The last category is tax efficiency.  For many investors who hold a well-diversified portfolio, the location of various types of assets can make a significant difference in their long-term performance if certain types of assets are placed in tax accounts and other types of assets are placed in tax-deferred or tax-free accounts. For example, taxable bonds and non-qualified dividend-producing REITs are better placed in a tax deferred account.  Securities with good long term potential for appreciation, such as common stocks, belong in a taxable account, which takes advantage of the lower long-term capital gains tax rate.

A comprehension examination of each of these areas will determine the suitability of an investment portfolio and highlight areas for improvement. Cognitive Investing describes the rationale behind this methodology and by applying its core principles, you will be well on your way to making better investment decisions.

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