A Diverse Portfolio is a Key Tool for RIAs to Serve Their Clients

It’s the simplest, and smartest, way to navigate the market.

Whether you talk to an accountant, an insurance agent, a stock broker, or an independent investment advisor, there is one thing they are likely to agree on when it comes to building an investment portfolio—the importance of diversification. Despite all the changes in the economy and financial markets, portfolio diversification remains as critical to minimizing risk today as it did 100 years ago.

Bond and stock prices still typically move in opposite directions on interest rate news as do the stock prices of homebuilders and packaged consumer goods manufacturers and utilities. This has been born out time and again, including before, during, and after the Great Recession.

As an RIA, this means the more investment choices you have, the better, which is why you should consider working with an open architecture broker-dealer like Pushe Kaplan Sterling Investments.

Below we explore the questions of how to create a diversified portfolio, and what should be in it.

Naive vs. Optimal: Two Sides to Diversification

It is crucial that a client understand the two schools of thought when it comes to diversification—naive and optimal.

With naive diversification, the investor chooses a variety of securities to lower the portfolio’s level of risk. It is a simple, common sense method based on real-world assessments of a security’s performance in the market. Contrast this with optimal diversification, also known as “Markowitz diversification”, named for Nobel Prize-winner Harry Markowitz. According to this method, the essential aspect pertaining to the risk of an asset is not the risk of each asset in isolation, but the contribution of each asset to the risk of the aggregate portfolio.

A Word About Correlation

A key factor to consider when choosing an investment strategy is correlation, which is the extent to  which two assets move along the same general path. The general consensus is that a prudent investor will select assets that do not correlate—that is they are in different classes and operate on different cycles. This protects the portfolio should one asset class behave erratically.

This is where computer models can be useful, as they will track multiple asset classes and assess their long-term performance, a process that would otherwise be extremely laborious. That said, even algorithms cannot predict the future with certainty. Common-sense, personal evaluation of correlation may, in the long run, provide just as useful a snapshot as any computer model.

Diverse Portfolios—Some Tips for Clients

As is well known, a diverse portfolio consists of a variety of financial products that represent a wide range of industries and degrees of risk. Recommended vehicles to include are cash, stocks, bonds, mutual funds, exchange traded funds (ETFs), and other assets. Make sure to include investment vehicles that have varying rates of return and direction, which allows an investor’s portfolio to handle one or more type of asset declining at any given time.

Within these categories, there are some key considerations to keep in mind for any diverse portfolio:

  • Stocks: An aggressive posture can make them unsuitable for retirees and other investors who depend on income from their portfolios to pay living expenses. Strive for diversity by varying the market capitalization (small, mid, large), industry, geography, and sector. Choose a mix of styles, like income, value, and growth. No one stock should make up more than five percent of a portfolio. Also consider working with a partner that has direct selling and servicing agreements with a wide variety of mutual fund companies.
  • Bonds: Fixed income investments are useful tools to mitigate risk and reduce volatility. These typically include municipal bonds, government-sponsored projects, and mortgage-backed securities. As always, bonds should be evaluated according to how their credit ratings and maturities match the client’s financial goals.
  • International Stocks: These enable clients to participate in faster growing overseas markets, but must be monitored closely for geopolitical and currency risk.
  • Additional Options: Also worth considering are sector funds, commodity-focused funds, real estate funds, and asset allocation funds to round out a client’s holdings.

Vigilance Stewardship is Key

Risk management requires constant vigilance, particularly as clients approach retirement. RIAs must regularly assess portfolios to ensure that they are structured to deliver the desired returns within the client’s risk tolerance. Every investor has their own threshold. An RIA’s primary role is to push performance up to the edge of the client’s comfort zone, while always honoring their expressed limits.

In the end, common sense and a proactive approach will serve you well as you assemble a diverse portfolio. Consider PKS Investments as a trusted investment partner who can add a level of expertise and access, with a wide array of products and services.