Portfolio Management

LET’S discuss a few important things to consider so you can optimize the way you implement your plan and maintain it over time.

1. YOUR RISK PROFILE

One of the most important decisions you’ll make as an investor is defining your risk profile. There are countless definitions of what a risk profile is – and even more methods for determining yours. The most common approach is to go through some sort of profiling questionnaire. This is how most advisors and firms perform risk profiles and I have to admit that I don’t love that process because it generally involves a bunch of generic, cookie-cutter questions that everyone knows the “right” answers to.

For example, I used to send clients a question about how they might respond to a large market downturn. Predictably, everyone gave the textbook answer – you’re supposed to buy during a downturn, right? But the problem is when the stock market falls 30% during something like Covid, most of us will be fearful and assume that the downturn is not over yet. We get frozen by fear because we assume the 30% downturn is the start of a 50% downturn. We hesitate, we wait, and then we miss the recovery. In practice, the emotions don’t match the survey responses. So these questionnaires end up being useless because they measure theory, and not realistic behavior.

Another approach is to use something more systematic like the age-in-bonds rule or a target date fund approach. Those are fine options, but very general. As I’ve already noted, something like the age-in-bonds rule could serve you broadly well, but in certain circumstances, like retirement, could also serve you precisely wrong.

I prefer to use the aforementioned asset-liability matching approach. As I noted in the Defined Duration chapter, your risk profile is really a function of any asset-liability mismatch. People say they sell stocks during a bear market because they’re scared – but what they’re really craving is the certainty that cash provides across time. The root of the problem isn’t just fear; it’s the uncertainty baked into a misaligned asset allocation. The solution is to increase certainty in your portfolio. And you do that by building a sound financial plan and understanding how your assets are designed to protect you over time. In the context of the Five Pillars of Defined Duration – if you knew you had two years’ worth of cash set aside to cover near-term expenses in Pillar One and then another 20% of your portfolio in safe short-term instruments in Pillar Two, you’d be far less likely to panic and sell stocks during a downturn because you have so much embedded certainty over your ability to ride out a stock market downturn.

We created a quant-based risk profiling tool at Discipline Funds to help investors obtain a better understanding of their risk profile by implementing an asset-liability matching profile. Instead of assigning assets based on vague behavioral assumptions, the tool matches your assets based on a specific financial plan and then fills in the blanks. You can find the Portfolio Builder, Risk Profiling tool, and much more at www.ria.disciplinefunds.com/tool-suite.

2. INVESTMENT VEHICLES

As you know by now, I am a big fan of ETFs. There are a few unique cases here where I am open-minded to mutual funds (like interval funds or hedge fund replicators, which wouldn’t work well as ETFs), but in general I think you should adhere to a mostly ETF strategy. The one major exception is owning individual government bonds, which are functionally diverse in that they’re liabilities of the biggest income-generating entity in human history. The other obvious exception is when a product cannot be replicated using liquid underlying instruments.

The secret sauce of ETFs is that they provide a very tight correlation between the actual ETF and the underlying instruments the ETF is designed to track. But the underlying instruments need to be somewhat liquid. They have to be traded actively enough to give us a reasonably real-time pricing structure to allow the market makers to make the ETF work well in the first place. This is why mutual funds and private label funds can sometimes be better wrappers for less liquid strategies.

3. INVESTMENT ACCOUNTS

As we noted earlier, the way you house your investments can make a big difference. You should always aim to optimize the use of vehicles like Health Savings Accounts, IRAs, 401(k)s, LLCs, and Trusts to help protect and efficiently structure your assets.

Further, be mindful of the way you allocate your assets across specific account types. Many of these accounts, such as IRAs, are specifically designed to be longer-term investments and therefore give you the flexibility to be much more aggressive there.

4. REBALANCING

There isn’t strong empirical evidence about the optimal way to rebalance, except that less is often more. In general, I lean toward rebalancing annually or less frequently, both to reduce unnecessary trading and to take advantage of lower long-term capital gains tax rates when possible.

Your plan will evolve over time, and rebalancing is a necessary part of the process. To avoid triggering huge costs along the way I think a once-a-year rebalancing rule is just fine. Then again, it very much depends on the asset and the portfolio or strategy you choose to employ. A more active strategy may require more active management. But all else being equal, less is usually more when it comes to rebalancing. Of course, there are always exceptions. As I’ve noted, I am very hands-on with cash, oftentimes rolling T-bills every quarter. So, it depends.

5. ACTIVITY

I’ve made it clear that we’re all active investors, and there’s nothing wrong with that. But beware of being overly active, which can lead to excessive taxes and fees. Taxes are the biggie here, and it’s always smart to limit unnecessary tinkering that might trigger short-term capital gains.

At the same time, don’t be afraid to scratch an itch if it helps you stay disciplined more generally. If keeping 5% of your portfolio in individual stocks that you actively trade makes it easier to stick with a 95% indexing core, that’s a perfectly reasonable trade-off.

6. FINANCIAL MEDIA

Don’t be afraid to consume financial media, but keep it in the right perspective. Consuming financial news is mostly about staying informed and not so you can jump on the latest investment craze. There are millions of people trying to get your attention and hoping you’ll react to their narratives. Financial media is especially hopeful that they can grab your attention, oftentimes preying on your emotions in the process. It’s their job to generate eyeballs, not to give you sound advice. After all, if the financial media was accurate they’d write the same thing 95% of all days of the week and it would sound something like this:

The markets went up and down, nothing much interesting happened, and people mostly went about their lives in a disinteresting manner.

Instead, they’ll focus on exciting short-term market moves and whatever fearful narrative is consuming the markets at present. And look, there’s nothing wrong with focusing on big risks out there and staying informed. I watch financial TV every day and consume an egregious amount of financial news. But just be sure to consume financial media with the right perspective and a critical eye so you don’t overreact.

7. FEED THE BEAST

The secret sauce to any good relationship is to keep feeding it and reinvesting in it. Buffett’s secret wasn’t just great stock picking. It was consistently contributing to a disciplined plan regardless of what was going on.

As Nick Maggiulli, an advisor and author of a fantastic book by the same name, would say, “JUST KEEP BUYING.” You need that Buffett cash-flow machine to keep feeding the beast over time. This not only helps you dollar cost average (unemotionally buying in a consistent manner over time), but it helps consistently take low or zero interest-bearing instruments (your cash income) and reallocate them to higher return-generating instruments. This is an essential piece to keeping your plan healthy.

8. WITHDRAWAL RATES

When you enter retirement, you’ll inevitably go down a number of rabbit holes about optimal withdrawal rates. The general rule is something like the 4% rule, but I believe you need to go into excruciating personal detail to quantify this concept. General rules will never apply to you at a personal level.

When you’re navigating the lifetime of your perfect portfolio it’s going to be important to remember that we cannot control the return of the markets, but we can control our spending. You may not know what stocks will do, but your expenses are far more predictable and manageable. In retirement especially, it’s important to have a clear understanding of your liabilities and how they align with your expected asset returns.

Generic rules will be good for general guidance, but you’ll need to get down and dirty with the specific details to assess this properly.

9. RETIREMENT PLANNING

As I discussed in multiple chapters, retirement is likely to be the most difficult financial transition you undergo. This is going to be the period in your life where having a plan and certainty will be most important.

The one big key here is to plan ahead. The transition into retirement is difficult for many people because they didn’t properly prepare for it. But when you have a plan, like a bond tent or similar approach, then you can better process the difficult transition periods of early retirement.

So don’t wait. The earlier you start building a plan, the better. It’s important to have a general plan or direction in your early investing journey, and when you reach your 40s or 50s you want to further refine and organize your retirement strategy so you can reach your 60s and ultimate retirement with comfort and confidence.

10. ESTATE PLANNING

A perfect portfolio is optimized when it’s most useful for its beneficiaries. And for some of us, our portfolios are likely to become someone else’s portfolios at some point in time. Your spouse, children, and other beneficiaries need to be considered in the scope of creating your perfect portfolio because they could ultimately be the ones relying on that portfolio. And this is where sound estate planning comes into play.

Good estate planning means working with an estate planning attorney or financial planner to help you tie up any loose ends in a broader plan. This includes tax planning, trusts, wills, and ensuring that you have beneficiaries assigned on the proper accounts. Your perfect portfolio will appear highly imperfect if your beneficiaries end up having to go through the court system just to get access to it.

Speaking of spouses and estate planning – I deal with this problem far too often so I’ll just say it – talk to your spouse about money. Far too many couples let one spouse handle all the finances only to confront an environment in the future where the other spouse now has the responsibility and is in the dark and unprepared. Don’t be those people. Perhaps the most important part of your perfect portfolio is making sure you and your spouse both understand it.

11. PATIENCE AND DISCIPLINE

It’s only appropriate to finish this book with a note about patience and discipline. If I had to pick the most essential element of investment success it would be understanding time. Patience and discipline are the essential ingredients to navigating time in the investment landscape.

Patience and discipline aren’t just virtues – they’re the foundation of lasting investment success. Markets will rise and fall. Strategies will come in and out of favor. But if you’ve built a plan rooted in your personal goals and grounded in time, your most powerful move is to stay the course. The investors who succeed aren’t the ones who chase every market move – they’re the ones who understand that real progress comes quietly, over years, through steady commitment. Build a plan you can live with, and then give it the one thing it truly needs: time.

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Gosh. I guess that’s all I’ve got to say. I hope you learned something interesting at the very least – and maybe, just maybe, found your perfect portfolio along the way.

If you’d like to talk more about your own search for the right plan, feel free to reach out at cullenroche@disciplinefunds.com. I would love to help however I can.

Thanks for reading – and as always, stay disciplined. . . and don’t skip leg day.