ARTICLES > > Why does planning precede asset allocation and manager selection when constructing a client portfolio?

Why does planning precede asset allocation and manager selection when constructing a client portfolio?

By Mike Kazakewich

“Our fiduciary approach to assisting clients begins with a highly focused and customized financial planning process.”

Landmark studies have shown asset allocation to be the single biggest contributor to the overall performance of a portfolio.  More meaningful than security selection or market timing, asset allocation has the potential to affect a client’s net worth in the most significant way.  In choosing a variety of different asset classes and managers that perform differently from one another, the investor can limit volatility and create more stable returns over the long-term.

If asset allocation and manager selection are so critical, why does planning come first when developing our client portfolios?

Our fiduciary approach to assisting clients begins with a highly focused and customized financial planning process. Through this approach, we gather the requisite client background we use to make recommendations that seek to address their financial goals and aspirations.  Our objectives as a planning-based firm are two-fold:

  1. Build a roadmap based on our clients’ current circumstances and future aspirations.
  2. Assist our clients in attaining their goals with the least amount of risk.

We believe the data gathering process is fundamentally important to develop a financial blueprint.  Ultimately, the more information we have about our clients, the better able we are to deliver a strategy that fulfills their needs.  We look to gather tax returns, brokerage and bank statements, will and trust information, insurance policies and real estate holdings amongst other items.  With this information on hand, we can build a client balance sheet, offering a complete picture of their assets, liabilities and net worth.  From there, we review the client’s income and expenses to determine if their lifestyle needs are adequately addressed now and in the future.  We model out to the 80th percentile of mortality rates to address the potential for clients outliving their wealth. Finally, we commence a qualitative exercise to understand all the client is seeking to achieve, their level of risk tolerance and their expectations for Coastal Bridge Advisors.

This information allows us to determine the required growth and income that we believe is necessary to execute our strategy. The plan is derived from probabilistic analysis and inclusive of variables and contingencies that may influence a client’s success. By undertaking the planning effort first, we can select a long-term asset mix that we can reasonably expect to deliver the required results as opposed to making an asset allocation based on emotion or investments currently in favor.

Our next step is to stress-test different asset allocation models.  To do so, we utilize a planning tool that applies a Monte Carlo simulation model.  What makes Monte Carlo modelling critical to our planning process is that it draws from a random and dynamic range of historical returns for the various asset classes and weightings for a prescribed asset allocation. We run a sample size of a thousand iterations to yield a probability of success for said asset allocation given a set of cash flow assumptions established during the data gathering process.  This sample size places an emphasis on the range of likely returns, rather than the volatility of returns in any given year of the planning horizon.  For an individual plan, we run multiple asset allocation prototypes before ultimately selecting the one that yields the highest probability of success in meeting the client’s long-term goals based on the modelling, while taking the least amount of risk, as measured by standard deviation. In our view, probabilities in the 80%-90% range are generally within the desired range offering the right balance of risk and expense.  By reviewing the plan on a regular basis, we are able to rebalance as necessary in pursuit of the desired outcome.

While asset allocation can provide a foundation for a portfolio’s performance, it is also reflective of the liquidity needs, tax efficiency and investment horizon of the individual. Target asset class weightings also reduce the emotional aspect when it is time to rebalance; take from the winners and give to the losers to maintain the overall allocation.

Once we determine the blend of assets, we turn to a universe of managers and investment vehicles to complete the client portfolio. We seek a broad array of managers; each highly specialized in their area of expertise and respective styles.  We select specific managers based upon a variety of criteria including fees, investment returns, tax implications, and experience and investment philosophy.

With the forward-looking component of the Monte Carlo stress test completed and the underlying investments and managers selected, we turn to analytical analysis based on historical performance.  By looking at the actual portfolio in a historical context, we are able to see how the recommended allocation would have performed in various market cycles and interest-rate environments.

Planning and analysis in this fashion allows us to quantify matters of risk. By arriving at a portfolio after careful testing and a complete understanding of the client’s objectives, we can make a determination about how much risk a client needs to undertake in order to accomplish their goals.  By regularly revisiting the financial plan to update the client’s asset base, cash flow assumptions and objectives, we can fine-tune the allocations and investments in light of changing circumstances and help to deliver their financial well-being.


May 2017