Wealth Management Advisors: Portfolio Modeling

Portfolio Modeling

Why is Portfolio Modeling important to you? On the one hand, you have delegated this to your Financial Advisor, so why do you need to know about it. On the other hand, we feel it could be helpful to you to have a basic understanding of our Portfolio Modeling Methodology.

Portfolio Modeling is important to us because it provides a rationale for us to match your portfolio investments with your stated objectives and tolerance for risk. Our starting point is our IPP (Investment Personality Profile) and IPS (Investment Policy Statement). We use these tools to develop an acceptable “Risk Budget” that you have approved while structuring the portfolio to achieve your goals. Another part of the consideration is your future needs for cash (we call it your liquidity needs). The Financial Road Map®* Conversation and IPS are key elements that we use to model a portfolio to meet your needs and give you the highest probability for achieving your goals.

We begin modeling your portfolio once we have scored your IPP & IPS (which should be rescored annually). Your profile can change through the years and one of the ways that we keep up with your changing life priorities is to revisit your Financial Road Map®* Conversation and IPS each year. Once completed, we establish an IPS Profile of 1 – 5. Profile 1 is a Conservative Income Profile. Profile 2 is an Income Profile. Profile 3 is a Balanced/Growth & Income Profile. Profile 4 is a Growth Profile. And Profile 5 is an Aggressive Growth Profile.

Many of our advisors use a “Bucket Methodology.” The idea is to establish different Buckets to place different portions of your portfolio. The target return for each Bucket as well as the holding period for each bucket is different from the other buckets. The result is a diversification of assets in the different Buckets… and a diversification of actual investments within the assets of each Bucket. The objective is reduced risk over the total portfolio. We design flexibility into some of the Buckets so we can respond to unexpected life events and possible needs for cash.

Some advisors use a “Four Bucket” approach. Bucket-1 is the Cash Reserve Bucket. Bucket-2 is the Fixed Income Bucket. Bucket-3 is the Equities Bucket. And Bucket-4 is the Alternative Investments Bucket. The first step is to establish adequate cash reserves… they go into Bucket-1. The second step is to establish your allocation to Alternative Investments… they go into Bucket-4. That leaves Buckets 2 & 3 for Fixed Income & Equities. We then divide the remaining assets between Buckets 2 & 3 based on a rationale that we derive from your IPS.

Other advisors use a “Six Bucket” or “Income for Life” approach. This is more typically used for clients who desire predictable income from their portfolio assets, and they want the highest probability that they will have the quality of life that they desire throughout the entirety of their life while preserving their current estate value to the end of their life. Of course, past performance is no guarantee of future results, and there is no guarantee that this objective will be fulfilled. In a world of uncertainty, all we can do is assess the risks and design a portfolio to manage them the best that we can while attempting to provide the highest probability of success.

Using the “Six Bucket ~ Income for Life” Portfolio Model, the first step is to establish the Cash Reserve requirement. Once the Cash Reserves are set aside, you can then move on to the Buckets of Money Modeling. Each of the six buckets has a specific purpose… a specific target rate of return… and a specific holding period.

Bucket-1

Provides Income for Years 1 - 5
Target Return of 2%

Bucket-2

Provides Income for Years 6 – 10
5 Year Holding Period
Target Return of 4%

Bucket-3

Provides Income for Years 11-15
10 Year Holding Period
Target Return of 6%

Bucket-4

Provides Income for Years 16-20
15 Year Holding Period
Target Return of 8%

Bucket-5

Provides Income for Years 21-25
20 Year Holding Period
Target Return of 10%

Bucket-6

Replaces the Portfolio in Year 26
25 Year Holding Period
Target Return of 12%

We then select investments that have the greatest probability of fulfilling the target return and holding period criteria for the respective buckets. Typically as much as half of the portfolio is in Buckets 1 & 2 with target returns of 2 & 4%, which means the bulk of the portfolio is on a more predictable and stable base.

The main objective of course, is to give our clients the highest probability of achieving their goals.