Portfolio Planning

It follows the logic to say that time in the market is safer than timing the market.

Author: David Bickerton
David Bickerton
David Bickerton
Asset Management | Financial Analysis

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management, investments and portfolio management.

David holds a BS from Miami University in Finance.

Reviewed By: Christy Grimste
Christy Grimste
Christy Grimste
Real Estate | Investment Property Sales

Christy currently works as a senior associate for EdR Trust, a publicly traded multi-family REIT. Prior to joining EdR Trust, Christy works for CBRE in investment property sales. Before completing her MBA and breaking into finance, Christy founded and education startup in which she actively pursued for seven years and works as an internal auditor for the U.S. Department of State and CIA.

Christy has a Bachelor of Arts from the University of Maryland and a Master of Business Administrations from the University of London.

Last Updated:January 3, 2024

What is Portfolio Planning?

Portfolio planning refers to the entire process involved in constructing an investment portfolio or a group of investments that may contain various asset classes, all while considering many things, such as investor expected return objectives, risk tolerance, and time horizon.

Generally speaking, this process is characterized by 4 main steps:

  1. Defining your investment goals
  2. Risk tolerance and asset allocation determination
  3. Creating your Investment portfolio
  4. Monitor, report, and update/rebalance if needed

However, portfolio managers and financial advisors are usually the qualified professionals in charge of drafting a formal document that encompasses the above considerations on behalf of the client/investor.

This formal document is known as an investment policy statement (IPS). It is a crucial step following the portfolio planning process outlined above as it helps managers understand what their clients are looking for in terms of investment opportunities.

In this regard, it is worth mentioning that systematic risk and expected return are inversely related, where higher risk goes in hand with higher expected returns.

importance of portfolio planning

The investment portfolio planning process is critical for anyone who cares about strategizing and maintaining their financial goals and objectives in a clear, focused, and methodological manner.

After having an appropriate blend of risk and reward in your portfolio, tracking your progress and rebalancing your portfolio with some frequency (such as once a year) will help maximize current and future performance.

Finding a standardized portfolio-planning strategy will help you gain investment discipline, a great skill that will assure you meet your goals, all while boosting efficiency and minimizing risks during market volatility or uncertain market conditions that may tempt investors to panic, sell, and accept unnecessary losses.

It follows the logic to say that time in the market is safer than timing the market.

The step-by-step portfolio planning process

The Planning Process encompasses the steps of determining the investment goals, and assessing the risks attached, any alternate investment opportunities, lastly, monitoring their performance. These steps are discussed in detail below.

Step 1: Defining Investment Goals

The first step in portfolio planning involves establishing your goals. During this process, the client meets with the portfolio manager to discuss the client's financial goals. The latter must be realistic and applicable to a specific time horizon.

Usually, short-term financial goals are paired with lower expected returns and vice versa. 

In order to match the best portfolio to the desired financial goal, a manager must determine where their client currently stands in terms of the 'wealth-creation-preservation-distribution' financial cycle. Returns are lower as you approach the wealth preservation phase, but future cash flow integrity increases.

Step 2: Risk Tolerance And Asset Allocation Determination

This step involves determining the client's risk tolerance and asset allocation. The former may be described as your willingness and ability to take on market volatility and can be found via a series of questionnaires conducted by the portfolio manager.

Some typical extreme risk profiles include conservative, moderate, and aggressive. One way to quantify risk tolerance is through the maximum drawdown (MDD) you are willing to accept; low-risk tolerance implies an MDD of 0-20%, 20-40% MDD for medium-risk tolerance, and >40% for high-risk tolerance.

Determining the client's risk profile also involves the discussion of the time horizon, liquidity needs, and return objectives.

On average, the U.S. stock market, as measured by the S&P 500 (dividends included), has delivered an average annual real return (inflation-adjusted) close to 8.5% since 1928; meanwhile, 10-year US T-bonds delivered around 2.30% annually.

Hence, aiming at a 2-7% annual real return looks pretty reasonable, depending on your risk tolerance.

The next sub-step involves matching your risk profile to an appropriate asset allocation. For example, going with the above risk profile, a possible allocation for a conservative investor or someone who wants to minimize losses at the expense of low returns but more excellent stability could be composed of 90-100% bonds (and others) and 0-10% equities.

A moderate investor would seek the widespread 40-60% equity and 40-60% bonds/others; meanwhile, an aggressive profile may be best suited for a 90-100% equity and 0-10% bonds/others portfolio.

Nonetheless, when undergoing the asset allocation process, your main goal should consistently be achieving optimal diversification while seeking targeted returns.

  • As a general rule of thumb, your recommended allocation towards debt and equity can be estimated as follows:
    • Equity allocation = 1 - your current age
    • Debt allocation = your current age

Main point: an investor's risk profile is never constant but rather ever-changing as their goals may change, particularly as you move along the 'wealth-creation-preservation-distribution' financial cycle.

Step 3: Creating Investment Portfolio

It is now time to create your portfolio and select your investment options. This is where the portfolio manager decides the appropriate investment strategy that fits your specific needs.

Deciding on the type of strategy is mainly dependent on whether the client is more into active or passive management, where the former involves more frequent buying/selling and higher transaction costs; meanwhile, the latter tries to replicate a specific benchmark via the use of passive investment such as index funds and ETFs.

Other portfolio management styles that the client may opt for are discretionary and non-discretionary portfolio management. As the name suggests, discretionary management entrusts the manager to invest at their discretion to achieve the client's desired returns.

On the other hand, non-discretionary management is where the manager gives the client advice, but it is up to the client what to invest in. This last portfolio management style is generally not recommended. 

When creating an investment portfolio, some standard products portfolio managers may offer you include but are not limited to stocks, bonds, mutual funds, exchange-traded funds, annuities, managed accounts, insurance products, bank products (such as money market accounts, CD's/GIC), wrap accounts, etc.

All of the products may sound somewhat overwhelming, but don't worry, investment managers exist in the first place! So always be sure to ask.

Step 4: Monitor, Report, And Update/Rebalance If Needed

This last step involves periodically monitoring your portfolio performance against your initial return objectives and the current economic landscape. Doing this will keep your portfolio and decisions in perspective.

Monitoring and reporting generally occur once the client and the portfolio manager establish a predetermined time frame to meet and discuss how the portfolio is doing about the client's risk-reward profile and, if not, rebalance the portfolio as needed.

Critical to this discussion is the continuity of the portfolio planning process. However, an investor's lifelong financial goals will undoubtedly change as he/she moves through different life stages.

As time goes by, time horizons change, along with economic variables, expected returns, and asset allocation preferences. Nonetheless, following this 4-step will always ensure you are on the right track.

Investment policy statements

As previously mentioned, the entire 4-step portfolio planning process, in addition to several other details, is described in a formal-crafted document known as an investment policy statement (IPS).

As the name suggests, this document is in charge of describing your investment goals and strategic roadmap and ultimately outlining your portfolio. The major components of an IPS are as follows:

1. Investment policy statement overview 

  • Client description
  • The overall purpose of the IPS 

2. Duties and responsibilities applicable to the manager and the client

3. Procedures

  • This section is in charge of stating how to manage individual circumstances as well as updating the IPS

4. Statement of investment objectives

  • Absolute and relative portfolio desired returns. 
  • Defines objectives in terms of the client's risk, expected returns, and liquidity.
  • Examples of investment objectives are capital preservation, minimizing concentration risks via diversification, maximizing quick ratio or risk-adjusted returns, long-term growth, and consistent returns to a given benchmark index for similar portfolio-strategy investments.

5. Investment constraints

  • Liquidity
    • As a textbook definition, having liquid assets implies an inability for buying and selling actions to affect the securities market prices or the bid-ask spread
    • Cash requirements by clients may incline them into wanting to invest more in very liquid investments.
  • Regulatory Constraints
    • Regulations on asset allocations, market regulations, investable asset classes, etc
  • Taxes
    • Tax implications depend on the type of investment account the client holds, the client's investment tax jurisdiction, etc
    • Tax implications, such as capital gains tax, may influence how a portfolio's assets are chosen and allocated.
  • Time horizon
    • A longer time horizon equates to higher risk, such as lower liquidity, but greater expected returns
  • Circumstances
    • ESG and other responsible investing factors that influence how a portfolio is constructed 
    • Circumstances surrounding portfolio construction may also arise from personal preferences such as religious beliefs or even specific market conditions.

6. Investment guidelines: Allowed and prohibited investments 

  • Laying out all permissible and prohibited investments that have been authorized as per the organization and IPS guidelines. Allowed and prohibited investments should be presented in a clear and concise manner, such as in a data table.
  • Selection of asset classes, use of leverage, rebalancing, credit, maturity, and concentration guidelines for each asset class should also be considered. This process defines the minimum credit quality, maturity, and exposure for each eligible investment type.

7. Portfolio benchmarks for performance evaluation

  • Having benchmarks helps managers assess the client's portfolio relative performance and risk. Some of the standard measures for this include alpha, beta, r-squared, standard deviation, and sharp ratio.
  • Benchmarks also help identify if your portfolio uses the best strategy, given your risk-return profile.
  • The frequency of evaluation and other additional information should also be stated.

8. Appendices

  • Details not mentioned in previous sections, such as rebalancing strategies and strategic asset allocation, risk hedging policies, responsible investing policies, allowed deviation from the benchmark, etc.

Real examples of the formal investment planning process/Investment policy statements can be seen in: example 1 and example 2.

Portfolio Planning: selecting individual stocks for your portfolio

If unsure about how to allocate your portfolio and what asset classes to include to obtain a desired expected return, Blackrock's capital market assumptions do an excellent job of laying out the following:

  1.  5-,10-, 15-, and 20-year expected returns
  2. Long-term expected volatility
  3. Long-term correlation for various assets, ranging from China-broad and European large-cap equities to US 10+ years government bonds.

However, If you are more of a hands-on person with a high internal locus of control, there are five things you should be looking at when analyzing specific companies:

1. Stock's historical price movement:

  • Look if the company's stock has outperformed other competitors over 1-, 3-, and five years. Similarly, check if the stock price movement has outperformed the overall market or benchmark over 1-5 years.
  • Try and understand why a particular company's stock has been trading the way it has over the past 1-5 years. Any catalyst or bad news, perhaps?

2. Industry research

  • Please do your homework and always try and understand the company's industry, its competitiveness, and the role of the company of interest in its overall industry.
  • A company's 10-K filings may help understand its key strengths, weaknesses, and essential competitors.

3. Investigate the company valuation

  • Some valuable metrics include P/E, PEG, P/S, P/FCF, and EV/Sales. Comparing these ratios against their market/industry average and competitors will give you an idea of whether the company is currently trading at a historical premium or discount to itself and competitors alike.

4. Investigate the company's fundamentals 

  • Good comparable metrics (against market/industry and competitors) include revenue growth, EPS growth, operation margins, ROIC or sales-to-invested capital, ROA, ROE, current ratio, quick ratio, debt-to-equity, and dividend yield.

5. Investigate how risky the company

  • Understanding risk, such as through the company's beta, net debt/EBITDA, and monthly volatility, is significant when determining an investment risk-reward opportunity.

6. Check for technicals/current market sentiment on the company.

  • Researching the average analyst rating by investment banks, as well as what insiders are doing (i.e., net buying or selling activity) and institutional ownership, is significant regarding a company's momentum and prospects.

Similarly, researching how much higher or lower the company's stock is relative to its 50- and 200-day average can give you an idea of where the stock could be heading, mainly if you apply the notion of markets being mean-reverting in the long run.

  • If you are knowledgeable about technical analysis and you are not a firm believer in the weak form of the market efficient hypothesis, then looking at price formation patterns and using technical indicators may help you spot a good "entry point" (i.e., point in time to buy/start a long position)
  • Alighting valuation and fundamentals with technicals will improve your portfolio's overall risk-adjusted returns.

7. Macro-factors   

  • More often than not, a company's stock prices are correlated to more than just fundamentals, technicals, and valuation. 
  • Economic factors such as interest rates, exchange rates, inflation, unemployment, and overall consumer sentiment play a massive role in the market and hence individual-company performance. 

Understanding at what point of the business cycle we are currently at will help you better position your overall portfolio in such a way that you may take advantage of some opportunities but also hedge against potential risks.

For example, consumer staples and healthcare companies tend to do well in the business cycle's inflationary and even stagflationary phases. Meanwhile, banks tend to do well in a rising interest-rate environment. 

Example Of How To Analyze A Company Using The Fundamental, Valuation, And Technical Analysis

If a company has higher-than-market EV/sales and P/E ratios, all while having a lower-than-market free cash flow yield, then it could be that its stock is too expensive/overvalued.

Nevertheless, in order to check if the higher-than-market valuations are justified through fundamentals, looking at the company's revenue growth over the past 1-5-years and operating margins vs the market (and its 5-year average) may tell another story (ex. high growth but low profits are typical of growth stocks).

Looking at the company's risk via the reported beta or monthly volatility will let you know if the stock is too risky given its current valuations and fundamentals or not

Lastly, looking at sentiment is equally important. If, for instance, the company is rated a "hold," this is not good news as investment bankers are usually biased towards buy ratings. In other words, a "hold" or "sell" rating does not have much of a practical difference.

Looking at net insider buying and price-trend deviation from the company's 50-200 week average can give you an idea of the stock's current and future momentum.

Portfolio Planning: Essential Considerations

An investment manager needs to be aware of the demands, limitations, and circumstances of their clients in order to manage their portfolios successfully. To be more precise, the investor's expected return needs to match their level of risk tolerance.

It makes sense that investors should receive payment for the systemic risk they assume.

There are essential considerations that should be taken into account in portfolio planning. Some of them are listed below.

1. Asset allocation and diversification are the keys to long-term success

According to a famous paper cited by Vanguard in a research paper titled Principles Investing Success, a proper mix of well-diversified asset holdings (i.e., asset allocation) accounts for up to 91.1% of a portfolio's returns and volatility risk over time, while only 8.9% comes from security selection and market timing.

2. It's nearly impossible to pick individual stock winners consistently.

If unsure about how to select or analyze individual stocks, it's best to stick to low-cost ETFs

3. Time in the market is a far better strategy than timing the market

According to investment manager Capital Group, the longer you are in the market, the better are the chances of better returns as the more days missed' in the market yield steeper losses;

  • An original untouched investment of $1,000 in the S&P 500 would have grown to $2,775 (excluding dividends, yielding an average annual return of 10.75%) from 01/01/09-12/31/18, compared to a $712, or 28.8% loss, if missed the 40 best days of the S&P 500.
  • Over the past 91 years up to 12/31/2018, the S&P 500 yielded negative and positive returns of 27% and 73% each year, respectively. However, for 10-year periods, negative and positive returns occur only 6% and 94% of the time, respectively.

A final shocking stat that confirms the fact that timing is not essential for long-term investment success: 

  • Starting to invest at the best days (market bottoms) of the S&P 500 (market bottoms) would have yielded you an annual total return of 9.16% (from 1/14/1999-12/31/2018). meanwhile, starting on the worst days (market tops) would have still yielded close to 7% over the same 20-year period.

4. An all-stock portfolio is too risky for most

Based on a backtest performed by Finimize using the online software platform Portfolio Visualizer, it found that adding gold and bonds to an all-U.S stock portfolio:

  •  Significantly reduces annualized volatility and maximum drawdown.
  • Increases annualized alpha, Sharpe ratio, Sortino ratio, Treynor ratio, number of positive periods, and total gain/loss ratio, 
  • All while almost returning the same annualized return as an all-stock portfolio during the same time period (01/01/1972-06/10/2021).

Portfolio Planning FAQs

Researched and authored by Christian Algarañaz | LinkedIn

Edited by Colt DiGiovanni | LinkedIn

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