Best practices

Throughout the Achievable material, you’ve learned several concepts related to making suitable recommendations to investors. Here, we’ll review best practices that help you consistently arrive at strong recommendations. In particular, we’ll cover these four topics:

• Diversification
• Rule of 100
• Strategic and tactical asset management
• Passive vs. active management

Diversification

Many financial professionals cite diversification as one of the most important investing principles. Markets are unpredictable and constantly changing. For example, who would’ve predicted 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 many examples of investors losing significant amounts due to concentrated positions in one company (or a small number of 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 who lost over $1 million in his retirement accounts due to Enron’s bankruptcy. His biggest issue was a lack of diversification. He allegedly held almost all of his retirement savings (roughly $1.3 million) in Enron stock, which benefited him during the stock’s dramatic rise in the late 1990s. However, his retirement nest egg collapsed after revelations of Enron’s fraudulent accounting practices caused the stock to become worthless.

A lack of diversification in an investor’s portfolio is a major red flag. Even if a concentrated investment has performed well, putting significant sums into one (or just a few) investments is seldom a good idea.

There are exceptions. For example, a life cycle fund is typically made up of multiple mutual funds, and each of those funds may hold dozens or hundreds of securities. Index funds and exchange traded funds (ETFs) that track broad indexes (like the S&P 500) can also provide high levels of diversification through a single investment.

A common diversification issue comes from employment-related benefits. Employees of publicly traded companies are often offered company stock at a discount, or even as a free benefit. An investor may 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 lack of diversification exists and recommend broader variety in the client’s holdings.

Rule of 100

An investor’s age is a key factor in suitability. In general, age and risk tolerance tend to move together:

• Younger investors are more likely to be suitable for aggressive strategies with higher risk.
• Older investors are more likely to be suitable for conservative strategies with lower risk.

We previously discussed the rule of 100 in the common stock chapter. This general guideline says:

• 100 − the investor’s age = the percentage allocated to stocks
• The remainder is typically allocated to bonds

For example:

The rule of 100 isn’t absolute, so exceptions can be suitable. For example, an 80-year-old multi-millionaire who 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.

Use the rule of 100 as a starting point for the average investor at that age. Then adjust based on the investor’s full situation (the “big picture”) when unique circumstances exist.

Strategic & tactical asset management

Investment advisers typically use one of two asset management approaches: strategic or tactical.

Strategic asset management means setting a long-term asset allocation plan. For example, here’s a suitable allocation for a 40-year-old investor saving for retirement:

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 keeping this allocation for the foreseeable future.

Once the recommendation is accepted, the adviser will adjust the portfolio to match the target allocation. That may require selling securities the investor currently holds. 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.

After the portfolio is set, the allocation will naturally drift over time as different assets perform differently. If the common stock market outperforms the fixed-income market, the common stock percentage will rise and the other percentages will fall. After several months, the allocation might look like this:

When the portfolio drifts too far from the original strategic allocation, the adviser should recommend rebalancing. In this example, 15% of the common stock would be sold, and the proceeds would be invested 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 plan. This is often done to take advantage of short-term opportunities or to reduce short-term risk.

To see how this works, start with the original strategic allocation for our 40-year-old investor:

If an adviser shifts away from this long-term allocation for short-term reasons, that’s tactical asset management. For example, suppose the adviser expects fixed-income markets to significantly outperform the common stock market over the next six months. The adviser might shift the portfolio to:

The portfolio would remain allocated this way 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 would sell the “added” fixed-income positions and reinvest 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 situation and goals:

• Strategic asset management sets a long-term allocation and uses rebalancing to maintain it.
• Tactical asset management makes short-term shifts away from the long-term plan.

Active & passive portfolio management

We previously discussed active and passive management styles in the ETF chapter. Let’s revisit how they relate to suitability.

Active portfolio management involves selecting individual securities with the goal of “beating the market.” Here, “the market” means the broad market for a given asset class. For example, an actively managed large-cap common stock portfolio would try to outperform the S&P 500, a broad stock index that tracks 500 large U.S.-based companies.

Active managers try to identify the best investments within a market. For example, a portfolio manager of an actively managed large-cap stock fund might choose 50 of the 500 stocks in the S&P 500, hoping those selections outperform the index. In practice, consistently picking winners 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 securities within that market. Buying every security in an index (like all 500 stocks in the S&P 500) would be difficult for most investors, which is why index funds and ETFs exist.

Investors often prefer passive management for two main reasons:

• Performance: Actively managed portfolios often underperform their benchmark portfolios (as noted above). This leads to an “if you can’t beat them, join them” approach.
• Cost: Active management requires more research and analysis, which increases costs. Passive managers generally follow an index rather than researching and selecting individual 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 chart below shows the cost of each fund using the average expense ratio for each and a $100,000 investment in each:

Expense ratios can be easy to overlook because investors don’t pay them out of pocket. Instead, the fund’s operating costs are taken from the fund’s internal assets, which reduces the return. Over long periods, a lower expense ratio can save hundreds of thousands of dollars (and even more for larger positions). 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 goal.