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?

3. The choice of active or passive management. How important is it that they strive to do better than the average investor (with the same risk posture)? In other words, how much effort do they want their investment managers to put into the outperformance game?

4. Downside risk. Is the institutional investor willing to accept more frequent small losses in exchange for less frequent large losses (hopefully minimizing their exposure to the next “2008-like” disaster)?

5. Peer comparisons. How important is it for them to look like their peers? (In other words, how different can they allow themselves to become and still remain comfortable?)

These five factors are in direct conflict—some are emphasized at the expense of others. So compromises must be made.

All too often, overenthusiastic investment salesmen will promise you can have it all—low cost, superior performance and limited downside risk. Unfortunately, such claims are nothing more than blatant over-promises that inevitably result in under-delivery. Any one of the five factors can be emphasized, but such emphasis is at the expense of the other four.

The Pros And Cons
Let’s consider the major pro and con for each of these factors for implementation of a policy allocation:

1. Minimizing costs.

The advantage of working to minimize cost is that it ensures the investor will do better than the average investor (and potentially two-thirds of all investors), after accounting for fees and expenses, over the long term.

The disadvantage is that an intense focus on minimizing costs requires you to set aside the other four factors. You cannot have it all.

2. Minimizing taxes.

For those investors in the highest possible marginal tax brackets, this benefit could potentially be far larger than all the other possible benefits. Tax minimization tends to be more rule-based and therefore more predictable and consistent than other approaches.  We know the tax code with certainty, therefore we can establish a portfolio management approach designed to minimize the impact of that tax code.

On the other hand, successful active tax management has a higher price and meaningfully interferes with (or flat out prevents you) from emphasizing the other four factors.

3. Attempting to achieve outperformance through active management.

Individual markets occasionally offer tremendous opportunities for investors to win sizable outperformance, and harvest gains from the large number of market mispricings (dislocations) while very few rivals are doing the same. Think of a lake populated with many large fish and no fisherman around other than you.

Unfortunately, often the opportunity for successful active management is poor at best.  Frequently, markets become quite efficient, eliminating virtually all significant opportunities to find mispricings. Think of a lake with very few small fish and numerous other fishermen besides you seeking to hook them.

4. Attempting to reduce your exposure to the most severe stock market collapses.

If this strategy is successful, the investor benefits by being less exposed to the most extreme stock market declines.

But in a world defined by modern portfolio theory, nothing is free. Over the long run, lower risk portfolios will also garner lower returns. The only way to maintain one’s expected return level, while at the same time reducing the chance he’ll suffer egregious losses, is to increase the frequency with which he expects to realize small losses.  In other words, it is impossible for so-called downside protection schemes to reduce your total risk while still maintaining your expected return.

5. Similarity to peers. (In other words, a portfolio that looks like other people’s.)

One finds comfort in the crowd. Many feel safer by minimizing their own differences from their peers.

But in the investment world, an ironclad rule is that if you want to do better than the crowd, you must out of necessity look different from the crowd.

A More Robust Advisor-Client Experience
A more value-added and durable advisor/client relationship results when the financial planner abandons the Marcus Welby approach to portfolio construction. The advisor must set aside his own personal preferences about costs, taxes, active management, downside protection, and peer similarity.

Instead, the advisor must engage the client in a robust discussion about the nature of these five factors. Such a dialogue allows the client to reveal his preferences for each and to determine what tradeoffs he wants to make (for instance, he should know if he wants active management, he must be willing to give up active tax management and be willing to pay more).

With this approach, the retail client follows the path long employed by institutional investors that considers alternative implementations (for example, choosing passive management at a lower cost, active management at a higher cost, etc.). The advisor now takes on the role of coach, helping the client understanding the pros and cons of different portfolio constructions.

Finally, and most important, the advisor stops doing things like placing tactical asset allocation managers in a client’s account because the advisor likes them. Instead, he repositions himself in the back seat, putting the client in the driver’s seat. The client determines the structure of his own portfolio based on his own preferences and understandings of the five factors that he now controls.

Rob Brown, PhD, CFA, is the chief investment strategist at United Capital Financial Advisors in Newport Beach, Calif.