If we accept for a moment a world in which modern portfolio theory holds true, then each of our clients should maintain a portfolio positioned somewhere along the efficient frontier. Such a portfolio will be defined by a normal asset allocation—for example, 50% stocks, 30% bonds, 10% commodities and 10% real estate or something similar. The determination of which efficient frontier portfolio is best suited to each investor is derived from five activities that are well understood and well within the investor’s control: spending (for lifestyle), saving (keeping money aside dedicated for investment), timing (knowing when you want to save or spend), setting risk (or the level of volatility in your investment portfolio) and establishing a legacy (knowing what assets you want to transfer to heirs).

A successful partnership between the retail investor and his or her investment advisor requires a careful examination of these five factors and the compromises your client must make choosing some over others. Your client’s determination of where to set the dial on each factor will determine the optimal normal policy mix. This is not the end of the journey, however, but only the first step. It begs the next question: “How does one best construct the intended asset allocation?”

After all, an infinite number of implementations exist for any normal portfolio. Clients must make choices about their costs, whether they want active or passive management, how they will manage their taxes, how much the asset allocation will be tactical and how much it will be strategic, what their downside protection will be, etc.

Unfortunately, it has become standard practice for planners to remove the client from the process of figuring out how to implement the policy. Typically, the choices are based on a financial planner’s own personal biases. Perhaps the client ends up with a tactical asset allocation manager or a market timer, not because this is what he wants or understands, but because the advisor prefers doing it that way. The client has lost both control and understanding.

This is sad, for it ignores the client’s understandings, preferences, and priorities. Such an approach harks back to a bygone era. Think of the 1969 television program Marcus Welby, M.D., starring Robert Young. In this show, the good doctor would observe, evaluate, diagnose and then tell the patient exactly what to do. The patients had no choice, no involvement, no alternative treatments and absolutely no understanding of the pros and cons of the solutions.

This quite dated approach to professional services relied on a false notion that the “expert” was all-knowing/all-seeing and little benefit could be derived from fitting the solution to the client’s own values, concerns and priorities.

Thankfully, the medical field has advanced beyond this “doctor in the driver’s seat” approach. But the retail investment industry has gone in the opposite direction—client portfolios are being designed for the advisor’s preferences and not the client’s.

Institutional Investors
This is not how it works in the institutional world. After long wrestling with the issue, institutional investors quite some time ago abandoned slavish reliance on whatever their investment consultant told them to do. In the U.S., endowments, foundations, defined benefit pension plans, and ultra-high-net-worth families base the implementation of their normal policy asset allocations on five factors:

1. Cost. This means asking: How much do they want to spend on their investment management solution (on the implementation and maintenance of their policy mix)?

2. Taxes. How important is tax minimization?