Resources

I hope your Thanksgiving was a salient opportunity to practice gratitude, one of the key ingredients to living a wealthy life. Why? Gratitude might help you sense when you have enough stuff, and encourage you to pivot toward buying time, a much more satiating flex.

One way to buy time is to invest your stored wealth in an intelligently diversified portfolio that has the potential to grow, eventually making work optional (or ensuring it remains so).

But how does a diversified portfolio come together? Here I’ll share our portfolio construction framework as we practice it at Target Rock.

Are you throwing investment spaghetti at the wall?

What’s a bad approach to portfolio construction? One could spend all day hunting the financial landscape for the hottest stock, the most undervalued security, the highest-yielding bond, the trendiest ETF, the latest coin that’s going *rocket emoji* to the moon. Stack rank this list. Put a lot of dollars into your highest conviction idea, some lesser amount into your second-best idea, and so on.

One of my favorite mantras coined by a mentor of mine Patrick Nolan, CFA®: “A portfolio of your best ideas is not necessarily your best portfolio”.

How can that be? Isn’t the point of investing to make money? And aren’t your best ideas for making the most money … well, the best?

Alongside gratitude, humility is another key ingredient for living a wealthy life as a successful long-term investor.

Everyone feels like a genius in exuberant markets like we saw in 2021. But if you apply the same filter to every investment idea, you end up with overlapping risks and no protection from the alternate state of the future – the one where you turn out to be wrong.

Therefore, it pays to have some “devil’s advocate money” as part of your investment approach. And if you are a professional investor who understands the math behind portfolio construction, you’ll be able to fine-tune your bets to make each of them deliberate, diversified, and appropriately scaled (another favorite BlackRock mantra of mine).

A Better Way: Benchmark, Budget, Invest, and Monitor

Hobbyist investors and even many professionals shortcut this process and go straight to the “invest” step. But without doing the pre-work (benchmarking and budgeting) or the post-work (monitoring), you end up with a clusterfield of a portfolio. Whether that portfolio best serves your long-term goals will slip further and further from your awareness and control.

A shout out to all my favorite former BlackRock colleagues who co-developed this framework with me, and to my partner Matthew McKee, CFA, CFP® for enthusiastically adopting it when I joined him at Target Rock.

1. Benchmark: Translate objectives to a high-level allocation

A benchmark (noun) is a reference point – a north star – both for what you should own and how it performs.

People benchmark (verb) when they compare themselves to others. Am I making enough money? Am I saving enough? Reading enough? Exercising enough? Am I getting married, buying a home, or having kids at the “right time”? Am I putting up my Christmas decorations too early?

In life and investing, you must decide who or what to compare yourself to and why.

The portfolio benchmarks we use at Target Rock have a couple philosophical underpinnings.

First, they are meant to broadly represent our core investable universe – publicly-traded companies of all sizes, industries, and geographies, as well as a wide range of bonds of all maturities from government and corporate issuers. Our clients might have or want exposure to other assets like real estate and private equity. The process still accommodates off-benchmark allocations in later steps.

Second, our benchmarks represent a “neutral stance”. We take the market’s relative valuation of different assets at face value, without attempting to overlay our own opinion.

To represent these asset classes, we use plain-vanilla market indexes that are designed for broad coverage of the universe, which weight their holdings simply by their market-assigned valuations.

A client’s investment benchmark is a mix of stock and bonds in a proportion that roughly matches their return goals and risk tolerance. We pencil in higher long-term returns for stocks than bonds, but with more volatility. So, for client accounts that have a shorter investment horizon attached, we might benchmark to a mix of 50% stocks and 50% bonds. On the other hand, a Zillenial comfortable with volatility will likely benchmark their retirement portfolio against 100% stocks.

At the end of the day, benchmarks help us evaluate performance. If a portfolio returns 10% in a given year, is that “good”? That depends on the time period in question, and how a benchmark behaved (not just how much it grew, but with how much risk, too). A portfolio that outperforms another with a lot more volatility is not a fair comparison. Without the appropriate benchmark as a reference point, short-term performance can be misleading or meaningless.

There is no rule that says your approach – in investing or in life – must resemble your benchmark or the one society imposes on you. But the reference point is there for a reason. If your approach differs from the benchmark, those differences should be intentional.

2. Budget: Evaluate potential trade-offs in return, risk, and cost

Everyone knows what it means to budget income and spending. The goal is to maximize the utility of limited resources with intentionality.

In the investment context, we define budgeting as the “spending” of risk and costs.

First, risk.

In step one, we roughly calibrate the amount of risk for a client to take, expressed as the proportion of stocks versus bonds. The budgeting step is where we explore ways to differentiate the portfolio from the benchmark in pursuit of a “better” investment experience. This could mean potentially higher returns, lower risk, or a more desirable set of externalities (e.g. lowering the carbon footprint of our investments without materially changing the risk and return dynamics).

When we differ from a benchmark, we’re making a bet with inherent trade-offs. We choose to underweight one security or asset class to overweight another. For those with stock compensation, the concentration risk of a single stock often eats up much of the risk budget, requiring thoughtful navigation.

It’s important to measure the impact of any given bet on the portfolio’s risk and return potential compared to the benchmark. When making multiple bets, we measure how they collectively impact the portfolio’s expected behavior in different market environments.

Again, we want our collection of bets to be deliberate, diversified and appropriately scaled. Over time, this has the potential to create small asymmetries in risk and return experience that could add up to a meaningfully better outcome.

At the beginning of the year, we placed a bet on value and dividend stocks. We sourced this allocation from our core US stock allocation, which naturally had a higher weight to large tech stocks that had grown to exert undue influence on the performance of the broad market. We could have been wrong, so we didn’t completely replace our core broad US stock allocation with value and dividend stocks. Instead, we calibrated the size of the bet carefully, and in the context of other active decisions we made in the portfolio.

Second, costs. Namely, fees and taxes.

Our clients must get what they pay for. As a fiduciary, it is our duty to understand the underlying fee structures of the investment vehicles we are buying on their behalf. In an email newsletter about investment extremism, I called out “Bogelheads” for their one-dimensional philosophy to minimize fees. Of course, lower fees are better than higher fees all else equal, but we believe there are some cases where slightly higher fees are worth paying to potentially drive higher returns, lower risk, or improved externalities.

Taxes can also hamper investment performance. In non-retirement accounts, we lean more heavily (relative to the benchmark, of course) into product structures, asset classes, and trading strategies that help minimize taxes.

3. Invest: Explore and select strategies

This is where the rubber meets the road. I like to point out that there are more ETFs for sale than there are stocks listed on the New York Stock Exchange. The ecosystem of investment products is complex and ever evolving. The desirability of products ranges from piles of dog poo, to hidden gems, to obsolete dinosaurs, to righteous mainstays.

Our job as advisors is to evaluate investment products after benchmarking and budgeting to find the right tools for each job in the portfolio.

In the example of our overweight to value and dividend stocks, we evaluated several ETFs in each category before landing on the ones that we ultimately used to express our view, based on a combination of fitness of exposure and cost.

If an investment idea comes to us that seems attractive in a vacuum, we must take a step back to “Budget”. What will we sell and how big should the position be to help improve our odds of accomplishing our clients’ goals?

4. Monitor: Measure and rebalance with discipline

The ongoing process of monitoring a portfolio has many dimensions.

First and foremost, we must stay in close touch with our clients about their evolving life circumstances to ensure our investment approach continues to match their goals and risk tolerance.

We also continuously monitor the market environment, not to distract ourselves with media noise and risk being goaded by fear and greed, but to stay attuned to obvious opportunities or risks.

For example, this year the investment landscape has fundamentally changed with the rise in interest rates. Bonds are materially more attractive relative to stocks and alternative asset classes compared to last year, spurring a shift in our strategy. You don’t need a crystal ball, but you do need to pay attention. Then, you need to find right way to translate an insight like this into action.

We also need to stay aware of the latest trends in product development. When will the righteous mainstay devolve into the obsolete dinosaur? Untold billions of investor assets are sitting in high-fee, low-tax efficiency investment funds – once the smart choices of their time – that are long overdue for inspection.

Lastly, we need to rebalance portfolios when they drift out of alignment from the benchmark. As stocks or bonds fluctuate in value over time, they may no longer reflect the ideal relative allocation. So, around once per quarter, we snap those allocations back into place, and do so with particular care in taxable accounts.

Is your investment strategy up to snuff?

I hope this sheds some light on how we think about investing at Target Rock and inspires you to handle your investments with the upmost intentionality and care.

If you are ever in need of another set of eyes on your investment strategy and how it fits into your broader wealth picture, we are always a phone call, Zoom meeting, or cup of coffee away. Schedule some time!