The first article in this series defined the concept of a shoebox portfolio. The second article focused on how to organize your account information. Our topic for this month is how to analyze the portfolio. The first step in the portfolio analysis process is to develop a customized investment policy statement. The statement should take into consideration the following eight critical investment factors:
- Goals. A portfolio may have multiple goals encompassing short-term, intermediate, and long-term time horizons. Multiple goals increase the complexity of the portfolio.
- Time Horizon. An immediate time horizon is within the next 12 months. Short-term refers to the time period between one and three years. Intermediate-term ranges between three and five years, and long-term is greater than five years.
- Risk. This factor refers to volatility of the portfolio. Minimizing downside risk is what comes to mind for most investors.
- Liquidity. This is the cash that must be generated or withdrawn from the portfolio to meet lifestyle goals.
- Diversification. A diversified portfolio contains enough unique investments so that if any single holding suffers materially, it will not “sink the ship”.
- Marketability. A financial asset is marketable if it can be quickly and easily converted to cash without a significant loss of value.
- Tax Consequences. Tax consequences are an important factor to be considered, but rarely, if ever, the most important factor when making portfolio decisions
- Inflation Outlook. This refers to the forecast for interest rates. There are certain investments that can be expected to perform well in times of rising inflation.
After the investment policy has been established, the next step in the investment decision process is to determine which broad asset classes will be used in the portfolio. The most common asset classes to consider are cash, bonds, stocks, or alternative investments. The third step is to determine the appropriate allocation to each asset class.
The next decision to be made is which sub-asset classes to include in the investment portfolio. Within the asset class of stocks, an investor could consider the sub-asset classes of U.S. vs foreign, large vs. small, and growth vs. value. Sub-asset classes for bonds include government vs. corporate, high quality vs. high-yield (low quality junk bonds), taxable vs. tax-exempt, and short vs. intermediate or long-term.
Only at this point, after taking the above factors and considerations into account, should the investor be adequately prepared to make the final decision of which specific investments to choose. It is useful to designate specific investments for specific needs, and match investment risk with goals and time horizon. Does your portfolio look like a shoebox?
Christopher P. Parr, CFP®, is a River Hill resident and president of Parr Financial Solutions, Inc., a Columbia-based, independent, fee-only, wealth management firm. He can be reached at 410-740-9011 or online: www.ParrFinancialSolutions.com.
This article was written for the May 2015 issue of River Hill Magazine.