The Toolbox of Portfolio Construction | Erik Averill, Justin Dyer | AWM Insights #72
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Episode Summary
One of the most important aspects of reaching your financial priorities over the long term is portfolio construction.
Just as important as putting the right players in the right positions on the field is the importance of understanding and utilizing the full toolbox for building your customized portfolio that takes into account all the complexities of your specific situation.
In this week’s episode, Erik and Justin discuss the basic building blocks of portfolios, avoiding amateur mistakes, and why your portfolio should be customized to you and your priorities – not some cookie-cutter model.
Episode Highlights
(00:44) The news you should know: Delta variant, Olympics kick off, Taleb thinks Bitcoin is worthless
(2:44) The building blocks of portfolios
(7:48) A customized approach
(8:21) Constructing the right lineup and avoiding amateur mistakes
(11:27) What we’ve learned from endowment models
(14:36) Is there a CFA constructing my portfolio?
(15:03) Are you getting comprehensive advice?
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+ Read the Transcript
Erik Averill (00:01):
Hey, everyone. Welcome back to AWM Insights. It's your Power Two Today. I am your host, Erik Avrill, and I am joined by my cohost, our chief investment officer, Justin Dyer. And here on the AWM Insights, each week we cut through the noise of what Wall Street is selling you to bring you the knowledge, skills, and access you need to invest like a pro. Today we're going to tackle the conversation about portfolio construction. We've spent the last few episodes diving into your financial structure, and today we want to hone in on the application of your actual investment portfolio.
Erik Averill (00:44):
But before we jump into that conversation, let's review some of the things that are happening in the news. As it seems to be every week, COVID still is at the forefront of the conversation. Now there are these scares over the Delta variant, and so just seeing how the economy and markets are reacting to that, we had a very surprising unemployment number tick up for the first time in a very long time, and so there's some concerns about that, that we continue to watch. On an exciting front, the Olympics kicked off and it's definitely going to be a unique year for the Olympics. Not a lot of fans out there, which is unfortunate for the athletes, but at the end of the day, you can always get behind rooting and for your country in the different sports. So, here as a sports family, we love seeing the Olympics start.
Erik Averill (01:36):
Interesting thing around the crypto space. Nassim Taleb, who is a famous author for known of authoring the books Fooled by Randomness, and also The Black Swan, is one of the foremost experts when it comes to probability, when it comes to game theory and mathematics, really published this incredible article stating why Bitcoin is truly worthless. We'll make sure to put that in the show notes. I highly encourage you to check that out.
Erik Averill (02:05):
And then kind of quick, quarterly just update or at least where we're at in the markets is, we've had some tough days in the previous week, but ended the week near that all time highs. We'll get some more into that information in this episode, but Justin, bring us into this conversation as we've talked so much around portfolio construction and financial structure. But I want to talk about when we choose our individual investments, or when we start to put together an investment plan, what exactly is portfolio construction?
Justin Dyer (02:44):
Well, let's start with some basics. Well, to answer your question specifically or directly, portfolio construction is how we take your financial assets. We're going back to your financial structure, your liquid, your cash, let's even dumb it down further, and invest that in the market. We construct a portfolio of assets using that cash to tie back into your financial structure and your specific priorities.
Justin Dyer (03:18):
Where do we start? So, let's take a step back even further than that. Where do we start? We need to ask ourselves, what's our toolbox? What are the tools that we have to actually construct a portfolio? Just like you're constructing a house, you want to have the right tools to do the job correctly. And that can be a number of different asset types or market types. So we talk about equity or a stock. So those are things that are traded on. If it's a publicly traded stock, those are these shares that are traded on publicly traded stock markets.
Justin Dyer (03:54):
I'm going to be super basic here, so apologize if I'm offending anybody's intelligence, but just so we're all on the same page, you have equity/stocks or debt. Really, those are two of the kind of underpinning, foundational asset types within portfolio construction. There's these things called derivatives. Those are options, call options, put options, things like that. But the word to describe those derivatives means they are related. They are derived, their values derived from a basic building block of portfolio construction, stocks or bonds. Stocks and bonds are really the two, again, foundational pieces that we have.
Justin Dyer (04:39):
Then you have private equity. Private stocks is another way of thinking about it, or private debt, or public. Public equity and public debt. So the nuance there is on public. Anything with the word public in front of it, we can buy or sell, or anyone can really buy or sell. You open up a brokerage account with Schwab or TD Ameritrade or Robinhood, and you can buy and sell these things on publicly traded markets.
Justin Dyer (05:07):
The private side, as we talk about quite a bit, is very unique and access really comes into play there. Another important criteria to think about when you're constructing portfolios, okay, do we invest all our money in our domestic economy, or do we diversify around the world? I'm sure most of our listeners know we are very much believers in a globally diversified portfolio, and we'll get into maybe a little bit of why diversification really does matter. It's kind of that one free lunch just as a teaser to that.
Justin Dyer (05:39):
So, those are the, let's say, kind of first level questions or tools that we have at our disposal to build a portfolio. And then there are some unique aspects that are specific to each and every client. How much money or what type of accounts do they have? How much money do they have in a taxable account versus a Roth account versus an IRA or 401k account? And then that allows us to put this overlay of asset location, as we call it, through this portfolio construction exercise to say, "Okay, well, each of these assets that are in our toolbox have different tax liabilities attached to them." A bond kicks off income. If it's a corporate bond, let's say, that's ordinary income. You're paying income taxes on that as though it was your salary, basically, versus an equity, a stock kicks off a dividend in most cases and that's tax slightly differently. And then there's also capital gains, which have unique tax characteristics as well.
Justin Dyer (06:48):
And so we want to put, and I know we've talked about this, but we do want to put tax inefficient assets in accounts that are more tax efficient, or kind of shield or defer the payment of taxes. So that's kind of that second layer of portfolio construction that we think through.
Justin Dyer (07:08):
But to craft these portfolios, what we do in a very unique way, tying this back to financial structure, human capital, and your unique priorities, is that they're completely customized to each and every single client. Where most of the industry today is using some sort of model portfolio, they're going to have a conversation with a client, and they're going to ask you, whatever, 10 different questions that are sometimes or usually a boiler plate questionnaire, and it's going to spit out some score and they're going to put you in a boiler plate 60/40 portfolio, is usually kind of one of the more custom. 60% stocks, 40% fixed income or bonds.
Justin Dyer (07:56):
Whereas we really, we take a step back. We work with the advisors, the relationship manager, wealth managers on the team to really, really, really know the client, their needs, their priorities. And Erik, you can touch on this side of it, where we then take those inputs, those conversations, and have a completely customized portfolio using these building blocks.
Erik Averill (08:21):
That was super helpful, and the things that are ruminating in my mind is a few things. First, the sports analogy. The reason we're talking about portfolio construction is no different than how do we construct a lineup in baseball. There is the one through nine hitter, and each of them have a very specific purpose of what's trying to happen within the game of baseball. We know historically you want someone to lead off who's going to get on base at a high percentage. There might be somebody hitting in, it used to be the three hole and may it now be the two hole, that is an impact power hitter that can put the ball over the fence. But what we don't do is take all power hitters who happen to have a high strikeout rate but a high slugging percentage and put them one through nine positions. You would never do that. You don't take one type of player and put him throughout the entire obviously lineup or on the field. There are specialty positions.
Erik Averill (09:24):
That's no different when it comes to your investments. What we see the amateur mistake made on a regular basis is never thinking through what does all the evidence say leads to ideal portfolio construction? It's just simply as an amateur, hey, I like this investment. There are risks that amateurs make of falling in love with a specific asset class and thinking that it should demonize everything else. As an example, falling in love with the asset class of real estate, then thinking that it's either real estate or everything else. And that's a misunderstanding, really, of what the evidence says.
Erik Averill (10:06):
The late David Swinson, who ran Yale's endowment for so long, when we think of endowment models, and you can shed some light on to this, is there is a construction of the different amount in each type of asset class, and what made him famous was obviously bringing in alternatives. But what David Swinson understands and every professional investor understands is when you make one investment, there's an opportunity cost and an impact of your entire portfolio, because as we've talked about, you have one net worth, you have one effective tax rate. And so it's an amateur move to look at an investment in isolation and think that your job is done.
Erik Averill (10:52):
It should really fit into the question of, how does this investment stack up against its benchmarks in its own little world? But then, how does it fit within my portfolio? Because a professional would have constructed a lineup or a portfolio to achieve your priorities. We always talk about one of the worst things you can do, another amateur move, asking your neighbor or your coworker or your teammate, "Hey man, what were your investment returns?" Because their investment portfolio is constructed completely different than yours.
Erik Averill (11:27):
So yeah, I would just love to hear your thoughts or maybe some detail around what we've learned from the endowment models and what the evidence says about constructing a portfolio. And I know we don't have all the time in the world in this podcast. We'll do that in the future deep dive.
Justin Dyer (11:46):
Yeah, we'll build on this, because it's hugely important. I mean, I love the baseball analogy. Constructing the lineup. You can go back to probably your mom or your grandma or whatnot as well, not putting all your eggs in one basket. That old adage certainly applies.
Justin Dyer (12:02):
But there's another critical aspect that I just want to touch on too, is not only is what Erik said the amateur move, where you're just swinging for the fences or you're just throwing a bunch of stuff at the wall and seeing what sticks and kind of, whatever, crossing your fingers in some cases. Even the so-called average financial advisor, wealth management firm, investment advisor, doing that 60/40 construction portfolio is missing out on an element of that. Yeah, maybe they're putting things together to be diversified. Hopefully they're globally diversified, et cetera, et cetera, but it still misses out on taking into account your overall financial structure.
Justin Dyer (12:48):
So kind of tying this back to your human capital, your priorities. It's very complicated to build a portfolio, taking those into account. And I don't want to get into the great details around that, but certainly reach out, have a conversation with our advisor team or wealth managers, and they can show you how we construct that financial structure, and then how that then ties into the portfolio management side of things.
Justin Dyer (13:15):
So how does that tie into the port for portfolio construction side of things? How does that work? Well, the priorities, your priorities, your unique priorities are really the key drivers of how we then start to build the portfolio. What is important to you over the next couple of years? What's important to you over the next 10 years? What does full-on financial independence look like? Do you have some discretionary, nice to have priorities? Each one of those goals, really, we categorize a certain way, and then we match that specific goal. We call it a liability because it's something that needs to be funded in the future. We match that with the proper assets in the portfolio.
Justin Dyer (14:03):
So, the portfolio is directly tied to your priorities and unique needs. Whereas most of the time, people constructing portfolios, again, are just throwing something at the wall, asking their neighbor what their returns are or what stocks they're invested in or whatever. And it's easy to do. It certainly is easy to do, but it's not optimal. It's not implementing an approach that will optimize your assets, or your net worth, really, to meet your unique financial goals and priorities.
Erik Averill (14:36):
And one thing I'll add to that, and as we close out here, is going back to the relationship you have with your certified private wealth advisor or someone like Justin, who is hopefully you have a charter financial analyst. I always make the comment that you should ask, is there a CFA who is constructing my portfolio? And if the answer is no, do not pass go, because you absolutely are working with an amateur at that point and not a professional.
Erik Averill (15:03):
But going back to us having one net worth, you have to take into account all of your objectives in all of your resources. And so, unfortunately, the way most of the financial world is set up is, is you happen to work with somebody at a brokerage firm, a Wall Street company, they are in a lockdown, limited investment platform. And so A, they do not have access to the best available investments across all asset classes. So that should already be a non-starter, is as a client, I want to be able to have access to every available asset class and hopefully the best in each one that there is.
Erik Averill (15:46):
And then the second thing is they are not able to, they're legally not allowed to start to advise or manage on those assets outside of their publicly traded platform. If you happen to have some private real estate, you happen to have some venture or some private equity, or just a 401k plan through your employer, is that investment advisor is not looking at your total portfolio. And as we'll get into in future episodes, it's really those private investments that are the juice behind the returns if allocated properly.
Erik Averill (16:25):
If you're in a situation when you start to think about investing, an amateur move is to only think about your publicly traded stock portfolio or just your private real estate, is there's this incredible world of amazing investment opportunities that are out there that you deserve to have access to all of them, and then you require the expertise who can manage and oversee all of that.
Erik Averill (16:51):
Hopefully this has been helpful. Like we said, this is a massive topic that we could go for days on. The future episodes, we're going to dig deep into each one of these topics, but until next time, own your wealth, make an impact, and always be a pro.