Options Are Great, But Too Many Can Be Debilitating
We recently installed an interactive LED light for our kids’ bedroom. You can make it change to any color in the rainbow. However, allowing them to choose their favorite has become a sure-fire way to extend bedtime indefinitely. They cycle through every color, then cycle through again and again, never able to make up their mind.
For many aspects of life, we have a multitude of choices. And if our preferences aren’t met, we can go custom. Oftentimes, though, a never-ending menu of choices hinders our ability to make an actual decision. Consider an investor building a portfolio for retirement. There are over 3,500 stocks, 8,000 mutual funds, and 2,200 exchange traded funds in the US alone. Constructing an optimized portfolio would be pretty daunting.
Our goal is to cut through the noise for our clients, and make things as simple and straight forward as possible. But on the back end, to optimize each allocation, we employ an evaluation process using a minimum of six criteria for each asset we recommend: cost, underlying index, index methodology, liquidity, tracking and risk. And since every client’s needs are unique, we leave latitude for customization to accommodate additional criteria, like focusing on ESG assets (environmental, social and corporate governance) or other client preferences.
First, there is the selection of portfolio type. We focus on three: passive, active index, and active. They all have their pros and cons, but the basic dividing line is cost. For brevity’s sake, let’s assume that you want low cost and are not interested in trying to earn above average returns. That means your portfolio will be passive and consist of broadly diversified index funds.
Regardless of portfolio type, a diversified portfolio starts with the global market. The most efficient method to build a completely diversified portfolio would be to own equal parts of every investable asset. Beyond being incredibly vast and expensive, such a strategy would require owning a lot of bonds, which, given their historically low rates of return, might not align with the investor’s needs. Since we aren’t going to include every asset under the sun, we let expected return, index exposure and risk drive allocation, which serves as a good approximation of optimal global weight.
A properly diversified portfolio leverages the underlying properties of the different asset classes to set appropriate levels of risk and expected return. An asset class is a collection of investments with similar behavioral characteristics along attributes like risk, liquidity and performance during different market conditions. The two most widely held are stocks and bonds.
We can break stocks down into large and small companies, and further by location. Both large and small companies can be split into domestic, international, and emerging market stocks. These six pieces are just different enough for them to be considered distinct asset classes.
The bonds we typically use can be split into three categories: government bonds, mortgage-backed securities, and corporate bonds.
For a standard, optimized portfolio, we can split our asset classes into six stock and three bond categories. The next step is figuring out which investments to use.
Continuing with our example, we’ve selected a passive, low-cost portfolio type, and split the global market into nine asset classes. Let’s assume that based on your growth goals and time horizon, your investment plan calls for an 80% stock and 20% bond portfolio. Now we need to fine tune our search and purchase our investments, which for large cap US exposure, will include low-cost index funds. There are over 1,500 funds to choose from. Since it would be prohibitively time consuming to research and track each one, we can use some basic screens to narrow down the options. Let’s also assume we want an index fund that tracks the return of US Large Cap stocks.
Using cost, tracking and methodology filters, we can shrink the universe quickly. Cost is one of the biggest determinants of real return for any index fund, so we are zeroing in on an investment that will track the return of our asset class for the lowest possible cost.
That leaves us with four options:
1. Vanguard S&P 500 Index at a cost of 0.03% (“VOO”)
2. iShares Core S&P 500 ETF at a cost of 0.03% (“IVV”)
3. SPDR S&P 500 ETF Trust at a cost of 0.09% (“SPY”)
4. Schwab US Large-Cap ETF at a cost of 0.03% (“SCHX”)
Three of the four are basically the same fund, just from different providers. Optimizing for cost, we’re left with Vanguard or iShares as the best options. But don’t give up on the Schwab ETF yet, we may still need it for tax-loss harvesting.
Tax-loss harvesting is a tax planning strategy that offsets capital gains by selling other securities that have experienced losses. Ideally, you sell stocks with losses and stocks with gains. This strategy can generate cash and lower your taxes. The caveat is you have to steer clear of the wash-sale rule which prohibits selling, then buying back the same security, or something “substantially similar”, within 30 days. If you do, you forfeit the tax benefit.
In our scenario, let’s assume you already owned VOO and it had lost money. VOO is your primary asset. We could sell it for tax-loss harvesting, but could not buy it back, nor any other S&P 500 index fund, within 30 days. Since SCHX tracks a different index, the Dow Jones US Large-Cap Total Stock Market, it would be sufficiently different, so we could buy it to maintain the same asset class exposure. SCHX is the secondary option is our tax-loss harvesting example.
With the Biden tax proposal making its way through legislation, for anyone with taxable investment gains, now is a good time to consider if tax-loss harvesting would benefit your planning strategy.
Completing the portfolio
A portfolio shouldn’t be complicated. It should provide an appropriate exposure mix to hit target growth and be optimized for risk, cost, and quality. If your portfolio includes 100s of positions tracking every index in the investible universe with multiple overlapping exposures, you might be getting less for more.
Ultimately, choice is great. But too many options can leave us with decision paralysis. Our approach is to simplify and streamline. We want to help clients avoid the confusion too many options can produce. That’s why we curate and deliver a few really good options that align with their objectives and meet sensible criteria.
If you'd like a second opinion on your allocation, one of our independent investment advisers would be happy to take a look, at no obligation to you.
Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of the firm's fiduciary service approach and directs all client engagement, service integration and investment management practices.
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