Throughout the Achievable material, you’ve learned several concepts relating to making suitable recommendations to investors. In this section, we’ll review and highlight best practices that will help you consistently find the best recommendations. In particular, we’ll cover these four topics:
Many financial professionals cite diversification as one of the most important investing principles. We live in an unpredictable, chaotic, and changing world. For example, who would’ve known that 2020 would 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 was trading around $30 per share in November 2019, only to fall to $11 per share in November 2020. To put this in perspective, an investor with a $100,000 portfolio fully invested in American Airlines stock in November 2019 would have less than $37,000 left in their portfolio one year later.
There are endless stories of investors losing significant amounts on concentrated investments in just one or a few companies. Examples include investors with large positions in Enron, Bear Stearns, and Silicon Valley Bank, all of which collapsed. For example, George Maddox was a plant manager at Enron that lost over $1 million in his retirement accounts due to Enron’s bankruptcy. His biggest fault was lack of diversification. He allegedly held almost all of his retirement savings (roughly $1.3 million) in Enron stock, which had benefited him during the stock’s dramatic rise in price in the late 1990s. However, his retirement nest egg came crashing down after revelations of Enron’s fraudulent accounting practices resulted in the stock becoming worthless.
Lack of diversification in an investor’s portfolio is a huge red flag. Even if the investment has performed well, investing significant sums of money into one or just a few investments is seldom a good idea. However, there are some exceptions. For example, a life cycle fund typically is comprised of multiple other mutual funds, which are each invested in dozens or hundreds of various securities. Index funds and exchange traded funds (ETFs) tracking broad indexes (like the S&P 500) also provide high levels of diversification with one investment.
A typical scenario related to a lack of diversification occurs with employment-related benefits. Employees of publicly traded companies are commonly provided company stock at a discounted price or even as a free benefit. An investor may feel comfortable investing significant amounts of money in the company they work for as they have an “insider’s view” of the business. Still, there are no guarantees (e.g., the George Maddox story). Financial representatives should identify when a lack of diversification exists, and recommend more variety to their clients.
An investor’s age is a critical component related to suitability. In general, risk tolerance and age are directly related. The younger an investor, the more likely they’ll be suitable for aggressive strategies subject to higher risk levels. The older an investor is, the more likely they’ll be suitable for conservative strategies subject to lower risk levels.
We previously discussed the rule of 100 in the common stock chapter, which is a general principle in finance. As a reminder, 100 minus the investor’s age determines the percentage of stock an investor should allocate in their portfolio. For example:
| Age | Stock % | Bond % |
|---|---|---|
| 30 | 70% | 30% |
| 45 | 55% | 45% |
| 60 | 40% | 60% |
| 70 | 30% | 70% |
The rule of 100 is not absolute, meaning there are exceptions. For example, an 80-year-old multi-millionaire that prefers an aggressive approach with a small portion of their net worth could be suitable for a 100% stock portfolio. Or, a 25-year-old unemployed investor with large debt levels may have no stock exposure. The rule of 100 should be used as a starting point and applicable to the average investor at that age. However, financial professionals should always weigh the “big picture” and adjust recommendations if unique circumstances exist.
Investment advisers typically utilize one of two asset management approaches: strategic or tactical.
Strategic asset management involves creating a long-term investment allocation strategy for an investor. For example, this could be a suitable asset 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 has been set if the adviser recommends this allocation for the foreseeable future. Once the recommendation is accepted, the adviser will move to match the allocation, which may involve liquidating securities the investor currently holds in their portfolio. If the investor were 100% invested in common stock, 40% would be sold and allocated to preferred stock, long-term bonds, and money markets.
After the new portfolio is set, the allocation will likely shift over time. If the common stock market outperforms the fixed-income market, the common stock allocation percentage would grow, and the other asset allocation percentages would shrink. It’s possible the allocation could look like this after several months:
| Asset | Allocation |
|---|---|
| Common stock | 75% |
| Preferred stock | 5% |
| Long term bonds | 17% |
| Money markets | 3% |
When the portfolio’s allocations shift too far away from the original strategic asset allocation, the adviser should recommend rebalancing the portfolio. To do so, 15% of the common stock should be liquidated, with the sales proceeds being invested in preferred stock, long-term bonds, and money markets in hopes of matching the original strategic asset allocation.
Tactical asset management involves deviating from the longer-term strategic asset allocation plan for short periods. This is often done to take advantage of short-term opportunities or shelter the portfolio from short-term risk. Before we go through the specifics of tactical asset management, let’s re-assume the original strategic asset allocation for our 40-year-old investor:
| Asset | Allocation |
|---|---|
| Common stock | 60% |
| Preferred stock | 10% |
| Long term bonds | 25% |
| Money markets | 5% |
If an adviser wants to shift away from the long-term strategic asset allocation for short-term purposes, they’re utilizing tactical asset management. For example, let’s assume the adviser expects the fixed-income markets to significantly outperform the common stock market over the next six months. They could shift the portfolio to this allocation:
| Asset | Allocation |
|---|---|
| Common stock | 45% |
| Preferred stock | 15% |
| Long term bonds | 35% |
| Money markets | 5% |
The portfolio will remain allocated this way for six months as the adviser believes preferred stock and long-term bonds offer higher return potential than common stocks. After six months pass, the adviser liquidates the “added” investments in the fixed income securities and invests the proceeds back into common stock to obtain the original allocation. This type of short-term investment strategy is a good example of tactical asset management.
Strategic and tactical asset management both involve creating suitable asset allocations for investors, given their financial situation and goals. Strategic asset management allocates assets with a long-term mindset, while tactical asset management deviates from long-term plans to take advantage of short-term opportunities.
We previously discussed active and passive management styles in the ETF chapter. Let’s revisit the topic to understand how it relates to suitability.
Active portfolio management involves picking a series of individual securities with an overall goal of “beating the market.” The “market” refers to the broad market for a given asset. For example, an actively managed large-cap common stock portfolio would attempt to beat the S&P 500, which is a broad stock index that tracks stock values of 500 large US-based companies.
The best investments are sought after when implementing an active management strategy. For example, a portfolio manager of an actively managed large-cap stock fund may choose 50 of the 500 stocks in the S&P 500 in hopes that their portfolio returns outperform the index. While it may sound relatively easy to pick the best investments in the market, very few portfolio managers can pull this off consistently. 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 identifying the best investments in that market. Investing in all the securities in an index (like all 500 stocks in the S&P 500) would be difficult, if not impossible for most investors. That’s why index funds and ETFs exist.
There are two big reasons why some investors are proponents of passive management. First, actively managed portfolios consistently underperform their benchmark portfolios (as we established above). It’s an “if you can’t beat them, join them” philosophy. If it’s so challenging to pick the best investments in a market, why not just invest in the entire market?
The second reason relates to cost. Actively managed portfolios require much more research and analysis than passively managed portfolios, which costs money and time. Portfolio managers of passively managed portfolios don’t have to spend any time picking and choosing specific investments; they simply follow the index.
Expense ratios of passively managed funds are typically significantly lower than 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 amount to a significant difference in return over long periods. To demonstrate this, let’s assume we have an actively managed fund and a passively managed fund, which both provide a 10% annual return over 30 years. This chart shows the cost of each fund, assuming the average expense ratio for both and an investment of $100,000 into each:
| Fund | Expense ratio | Total cost over 30 years |
|---|---|---|
| Actively managed | 0.60% | $264,061 |
| Passively managed | 0.12% | $56,213 |
Expense ratios are sneaky because investors don’t pay out of pocket. Instead, the cost of running the fund is taken from the fund’s internal assets, which reduces the overall return. Over a long-term period, a lower expense ratio can save hundreds of thousands of dollars (or even more for larger positions). Returns must consistently outperform their benchmark to justify the costs associated with active management.
Investors that believe passive management is the better strategy will attempt to invest in securities that mirror index movements, sometimes referred to as indexing. Investing in index funds, ETFs, and even index options can accomplish this goal.
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