Don’t Split Up Your Portfolio

Occasionally, we get questions from clients about whether it would make sense for them to manage the bond portion of their portfolio, while we manage the stock portion of the portfolio. After all, we’ve been in a pretty low interest rate environment for a while now, and bond returns aren’t adding much to the portfolio. It’s certainly tempting to compare those returns to the advisory fees that you’re paying, and it’s relatively simple to buy some bonds and build a bond ladder, or buy a few mutual funds that reasonably mirror the funds that we us in your portfolio. So, does this make sense? Is it actually worthwhile to manage the bond portion of your portfolio yourself?

Now, it’s worth noting that we’re obviously biased on this question. We wouldn’t be here if we didn’t think that we could help you, so let’s look at why we think that keeping everything in one place will help you in the long run – no matter what the markets do.

At McLean, we’re focused on true wealth management. We want to help you construct a portfolio that will help you prepare for and reach your goals. Investments are an important piece of this, but there’s more going on. In fact, the investments are the simple part. The complex stuff is all of the planning work around the investments, essentially figuring out how everything will work through time. These are the things that dictate what we are looking for from your portfolio and, in turn, what your portfolio will look like. This means that we take a comprehensive, holistic, view of your financial situation, and build your portfolio so that it fits within the bigger picture. If you’re simply looking for someone to give you a portfolio, and keep your portfolio rebalanced, we probably aren’t the right firm for you.

This being said, even if we just consider your investments by themselves, managing your stocks and bonds separately doesn’t make all that much sense. There are two big reasons for this: 1) breaking up the portfolio means it’s harder to manage, and 2) we design the portfolio to work as a whole. Let’s take a look at each of these two reasons separately.

When we manage a portfolio, we need to be able to see everything. We need to know how each piece is moving so that we can keep everything in alignment. An easy way to see how managing your stocks and bonds separately would cause big problems is to envision what would happen if we were doing this during 2008. During that year, stocks (the S&P 500 Index) were down 37%, but bonds (the Bloomberg Barclay US Aggregate Bond Index) were up 5%. This is going to cause some issues for your asset allocation.

Now, you could rebalance within each of these sections of the portfolio just fine, but it’s the ratio of stocks to bonds in your portfolio that really drives the level of risk that you’re taking. While you could have rebalanced within your stocks, or within your bonds, it would be difficult to rebalance between your stocks and bonds. You would have needed to write a check taking money out of the bonds that have done really well, and sent it over to buy a lot of stocks that had just cratered. To put it mildly, this would be a pretty tough check to write.

…But it would have been a really important check to write. In 2009, stocks were up more than 25%, and if you hadn’t rebalanced, then you would have completely missed that. In fact, markets tend to rebound quickly in general, which means that the friction generated by separating your stocks and your bonds could have significant effects on your long-term returns.

By keeping everything integrated, we can avoid this friction. We can keep the portfolio pointed in the right direction, and make sure that you always have the level of risk that your portfolio was designed around, and the level that is appropriate for you. If we split it up, we simply don’t have that transparency. We can’t react to the market to make sure that you are where you are supposed to be. There are no advantages from a portfolio management perspective.

We also want to consider that your portfolio was designed to work as a whole. We focus on building your portfolio from a holistic perspective. Both in terms of the investment portfolio itself, but also how it relates to the rest of your retirement income plan.

If you think of your portfolio like a hockey team, your stocks and bonds are playing different positions. Your stocks are the forwards putting up big numbers (and getting all of the attention), and your bonds are the defense. They don’t put up the big scoring numbers, but that doesn’t mean that they aren’t having a big impact on your portfolio. They are there to provide the stability that your portfolio needs so that you can feel comfortable letting the stocks do their thing. They are there to reduce the total level of risk in your investment portfolio, which means that we expect them to have relatively low returns by design. If your bonds get high returns, that likely means that something is going wrong within your portfolio.

If we were to take more risk on the bond side to try and get higher returns, that would mean that we would need to reduce the risk in your stock portfolio. That doesn’t sound so bad, but the data clearly tells us that we get paid more for taking risk with our stocks, rather than our bonds. We (largely) want our bonds to remain our trusty defense, because even though the bond returns will probably look lackluster, it will help the total portfolio in the long term.

This is important because your investment portfolio is just one piece in the larger jigsaw puzzle of your retirement plan. We want to set everything up so that all of the elements in your plan are pointing in the right direction, and we are taking the appropriate amount of risk for you across the entirety of your plan.

That means that everything in your retirement plan is interconnected. If you upset the balance in one section of your plan, that will have consequences for all of the other sections of your plan. And, for most people, your investments sit at the center of your plan. Changes to your investment plan can have huge impacts on how you have to manage the other pieces.

If we make it more difficult to manage your portfolio (and more difficult to control the level of risk in your portfolio) it makes the broader planning question almost impossible to solve.

To find out more about how we manage your portfolio on a day to day basis, read A Day In the Life of a Portfolio.