Creating and managing an investment portfolio that aligns with a client’s goals, risk tolerance and constraints is an important part of being a financial advisor. Advisors can choose from numerous strategies for constructing client portfolios. Options range from traditional asset allocation to market timing, as well as bucket and core-satellite strategies, and many others. Having a variety of portfolio construction strategies to draw from can help you to better meet the needs of a diverse client base.
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Portfolio Construction Principles
An investment portfolio construction strategy is a systematic approach to designing, building and overseeing a set of investments that will help an investor meet their goals while addressing individual risk tolerances and other limitations. The job involves gathering information about client needs and preferences, making decisions about asset allocations and specific securities, and balancing risk versus reward.
There are a number of distinct strategies for portfolio construction. It’s common for most advisors to blend different strategies to create personalized approaches that meet the individual needs of their clients.
Client Portfolio Construction Strategies
There can be as many different portfolio construction strategies as there are investors or portfolios. However, the major approaches or strategies often fall under one of the following:
- Strategic asset allocation. This is the traditional approach that’s been employed by financial advisors for decades. It involves creating a portfolio with a mix of assets aligned to the client’s risk tolerance and long-term goals. The classic asset allocation for a client with a moderate risk tolerance is 60% stocks and 40% bonds. Assets may include a combination of cash, equities and bonds, and sometimes alternatives such as real estate. This strategy is generally a buy-and-hold, long-term approach with periodic rebalancing to maintain the desired allocation.
- Tactical asset allocation. This strategy differs from traditional portfolio construction by allowing for short-term deviations from the strategic asset allocation in order to take advantage of certain opportunities or avoid risks. Similar approaches include dynamic asset allocation, active asset allocation and market timing.
- Core-satellite. A portfolio constructed using this strategy consists of a core of passive investments such as index funds or bonds to provide stability, along with a satellite portion of actively managed investments aiming for higher performance.
- Life-cycle. Like strategic asset allocation, this approach employs a long-term focus, with diversification and rebalancing. It adds an automatic, age-based risk adjustment mechanism that gradually shifts the portfolio to a more conservative allocation as the investor approaches their target retirement date. It provides a simple, hands-off solution for investors saving for retirement.
- Bucket. This strategy divides portfolio funds into three or so accounts, with each one earmarked to serve the client’s needs for a particular timeframe such as short-term, mid-range and long-term. The buckets help clients visualize the strategy and can help them resist poor decisions prompted by short-term market fluctuations.
Any strategy can incorporate investing themes such as growth investing, income investing and socially responsible investing within the framework. All strategies have advantages and disadvantages that may be highlighted in different circumstances, such as the bucket strategy’s difficulty in coping with extended bear markets.
Examples of Portfolio Construction
Choosing an appropriate strategy for a client is a vital skill for financial advisors. Here are two examples of common client types and the way specific strategies can be used to help construct their portfolios.
Low-Risk Portfolio
A client nearing retirement or with a low risk tolerance is often well-suited for a portfolio that emphasizes capital preservation over growth. In this situation, an advisor might tilt the traditional asset allocation toward more conservative assets.
For example, instead of the typical 60/40 allocation, the portfolio might consist of 20% stocks and 80% bonds, bond funds, cash and possibly annuities to provide stability and reliable income. Managing interest rate and credit risk may be addressed by diversifying fixed-income holdings across different bond types, credit qualities and maturities, and perhaps using techniques such as bond-laddering.
With a client very close to retirement, the asset mix might include a sizable bucket of cash equivalents such as certificates of deposit that could be drawn down to pay expenses for up to several years without exposure to market downturns.
Long-Term Retirement Savings
A younger couple 30 years from retirement with a higher-than-average appetite for risk might be appropriate for a core-satellite construction strategy. The 80% core could consist of low-cost index funds broadly diversified across domestic equity index funds, international developing and emerging market equity index funds, and bond index funds that own high-quality intermediate-maturity fixed income securities.
The 20% satellite portion could consist of actively managed investments offering higher risk and higher potential returns. Examples include healthcare or technology sector funds, actively managed bond funds seeking high yield, and alternative assets such as commodities and real estate investment trusts (REITs).
The goal of this strategy is to provide stability and diversification with the core, while preserving the opportunity for higher returns with the satellite portion. This strategy calls for regular rebalancing in order to maintain the core-satellite allocation, as well as adjusting the risk profile long term to become more conservative as the couple approaches retirement.
Bottom Line
Financial advisors have a variety of portfolio construction strategies to choose from when setting up a portfolio for a client. Each strategy has characteristics that make it more or less suitable to an individual based on their unique goals, risk tolerance and other traits. An advisor’s main tasks consist of gathering information about client characteristics, selecting asset classes and individual securities, and monitoring and adjusting the client’s portfolio.
Portfolio Construction Tips
- See what happens to a portfolio under different circumstances with SmartAsset’s investment calculator.
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