Throughout the Achievable material, you’ve learned several concepts related to making suitable recommendations to investors. Here, we’ll review and highlight best practices that can help you consistently arrive at strong recommendations. In particular, we’ll cover these four topics:
Many financial professionals cite diversification as one of the most important investing principles. Markets can change quickly and unpredictably. For example, few people expected 2020 to be the year drive-in theatres would experience a resurgence, or that the airline industry would take such a large hit. American Airlines (AAL) stock traded around $30 per share in November 2019, then fell to about $11 per share in November 2020. To put that in perspective, an investor with a $100,000 portfolio fully invested in American Airlines stock in November 2019 would have less than $37,000 one year later.
There are many examples of investors losing significant amounts by concentrating their money in one company (or just a few). Well-known cases include large positions in Enron, Bear Stearns, and Silicon Valley Bank, all of which collapsed. One example is George Maddox, a plant manager at Enron who lost over $1 million in retirement accounts due to Enron’s bankruptcy. His main issue was a lack of diversification: he allegedly held almost all of his retirement savings (roughly $1.3 million) in Enron stock. That concentration helped him during the stock’s dramatic rise in the late 1990s, but his retirement savings collapsed after revelations of fraudulent accounting practices caused the stock to become worthless.
A lack of diversification is a major red flag in an investor’s portfolio. Even if a concentrated investment has performed well, putting significant sums into one or just a few investments is rarely a good idea.
However, there are exceptions where a single investment can still be diversified. For example:
A common diversification issue comes from employment-related benefits. Employees of publicly traded companies may receive company stock at a discount or even as a free benefit. An investor might feel comfortable investing heavily in their employer because they believe they have an “insider’s view” of the business. Still, there are no guarantees (see the George Maddox story). Financial representatives should identify when a client’s portfolio is overly concentrated and recommend broader diversification.
An investor’s age is an important suitability factor. In general, age and risk tolerance tend to move together:
We previously discussed the rule of 100 in the common stock chapter. This general guideline says:
For example:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
The rule of 100 isn’t absolute. There are exceptions based on the investor’s full financial picture. For example:
Use the rule of 100 as a starting point for the average investor at a given age, then adjust as needed based on the investor’s goals, time horizon, liquidity needs, and overall risk tolerance.
Investment advisers typically use one of two asset management approaches: strategic or tactical.
Strategic asset management means setting a long-term asset allocation and treating it as the baseline plan. For example, here’s a suitable allocation for a 40-year-old investor saving for retirement:
| Asset | Allocation |
|---|---|
| Common stock | 60% |
| Preferred stock | 10% |
| Long-term bonds | 25% |
| Money markets | 5% |
This is a typical allocation for a 40-year-old (it matches the rule of 100). A strategic asset allocation is in place if the adviser recommends keeping this mix for the foreseeable future.
Once the investor accepts the recommendation, the adviser will adjust the portfolio to match the target allocation. That may require selling some current holdings. For example, if the investor is 100% invested in common stock, 40% would be sold and reallocated to preferred stock, long-term bonds, and money markets.
Over time, market performance will cause the percentages to drift. If common stocks outperform fixed income, the common stock percentage will rise while the other percentages fall. After several months, the allocation might look like this:
| Asset | Allocation |
|---|---|
| Common stock | 75% |
| Preferred stock | 5% |
| Long term bonds | 17% |
| Money markets | 3% |
When the portfolio drifts too far from the strategic target, the adviser should recommend rebalancing. In this example, that would mean selling 15% of the common stock position and investing the proceeds in preferred stock, long-term bonds, and money markets to move back toward the original strategic allocation.
Tactical asset management means temporarily deviating from the long-term strategic allocation. Advisers may do this to pursue short-term opportunities or reduce short-term risk.
To see how this works, start with the original strategic allocation for the 40-year-old investor:
| Asset | Allocation |
|---|---|
| Common stock | 60% |
| Preferred stock | 10% |
| Long term bonds | 25% |
| Money markets | 5% |
If the adviser expects fixed-income markets to significantly outperform common stocks over the next six months, they might shift the portfolio to:
| Asset | Allocation |
|---|---|
| Common stock | 45% |
| Preferred stock | 15% |
| Long term bonds | 35% |
| Money markets | 5% |
The portfolio stays at this tactical allocation for six months because the adviser believes preferred stock and long-term bonds offer higher return potential than common stocks during that period. After six months, the adviser sells the “added” fixed-income positions and reinvests the proceeds into common stock to return to the original strategic allocation.
Strategic and tactical asset management both focus on building suitable asset allocations based on an investor’s goals and financial situation. The key difference is time horizon:
We discussed active and passive management styles in the exchange traded funds (ETFs) chapter. Here’s how the distinction connects to suitability.
Active portfolio management involves selecting individual securities with the goal of “beating the market.” Here, “the market” usually means a broad benchmark for a specific asset class. For example, an actively managed large-cap common stock portfolio would try to outperform the S&P 500, a broad index that tracks 500 large U.S.-based companies.
In active management, the manager tries to identify the best investments within the market. For example, a manager of an actively managed large-cap stock fund might select 50 of the 500 stocks in the S&P 500, aiming for returns that exceed the index. In practice, consistently doing this is difficult. An analysis performed in 2019 found only 23% of actively managed funds outperformed their benchmark index over the previous 10-year period.
Passive portfolio management involves investing in the broad market without trying to identify the best individual securities. Buying every security in an index directly (such as all 500 stocks in the S&P 500) would be difficult for most investors. That’s one reason index funds and ETFs exist.
Investors often prefer passive management for two main reasons:
First, actively managed portfolios often underperform their benchmark portfolios (as noted above). This leads to an “if you can’t beat them, join them” approach: if it’s hard to consistently pick winners, investing in the whole market can be appealing.
Second, passive management is typically cheaper. Active management requires more research and trading, which increases costs. Passive managers generally follow an index rather than spending time selecting securities.
Expense ratios for passively managed funds are typically much lower than for actively managed funds. In 2021, the average expense ratio for actively managed funds (0.60%) was five times that of passively managed funds (0.12%). While the difference (0.48%) may seem small, it can create a large gap in results over long periods.
To illustrate, assume an actively managed fund and a passively managed fund both earn a 10% annual return over 30 years. The table below shows the cost of each fund, using the average expense ratios above and a $100,000 investment in each:
| Fund | Expense ratio | Total cost over 30 years |
|---|---|---|
| Actively managed | 0.60% | $264,061 |
| Passively managed | 0.12% | $56,213 |
Expense ratios can be easy to overlook because investors don’t pay them directly out of pocket. Instead, the fund’s operating costs are deducted from the fund’s assets, which reduces the investor’s return. Over long periods, a lower expense ratio can save hundreds of thousands of dollars (and even more for larger investments). To justify the higher costs of active management, returns must consistently outperform the benchmark.
Investors who prefer passive management often try to hold investments that mirror index movements, sometimes called indexing. Index funds, ETFs, and even index options can be used to pursue this approach.
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