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Jason Turner
Chief Operating Officer
Great Lakes Advisors

Typically, when individual investors set out to build a portfolio they base their investment decisions on achieving some specific goal, such as beating the return of the S&P 500 Index. To that end, they spend significant time looking for stocks, funds, or other investment vehicles and are often frustrated when those investments fall short. These investors make the critical error of focusing solely on investment selection while ignoring the most important determinant of portfolio success which is asset allocation or the mix of broad asset classes like large cap stocks, and investment grade bonds in their portfolio.

Even when investors do focus on asset allocation, they often allow their decisions to be guided by approaches based on outdated methodologies that rely too heavily on historical returns as a basis for the recommended portfolio. As we all know, past performance is not indicative of future results. Even those approaches that supplement history with forecasts still fail because those forecasts often do not fully anticipate downside risk. For instance, going into 2008, return forecasts varied widely from small losses to modest gains, and the reality of a 37% decline in the S&P 500 Index was far from most predictions. There is, however, a modern and advanced school of thought that can be leveraged to construct portfolios today.

We know that risk is a far more constant and predictable element than return. Using risk as a guide instead of return can help to smooth the experience by constructing portfolios that do well on average, and over time. By using this more advanced method of asset allocation, an investor’s portfolio is more closely aligned with goals and has a greater probability of success. The chart below compares the returns and risk of a balanced portfolio over time. The fluctuation in return from year to year is very evident, but close attention should be paid to the variation in the risk; the risk stays tightly controlled within a narrow range.

At Wintrust Wealth Management, we make use of this more advanced thought via an asset allocation approach that relies on establishing risk budgets in portfolios instead of trying to achieve an arbitrary return target. To better illustrate this risk budgeting process, imagine it in terms of a 10 ounce cocktail shaker which you can fill with different amounts and types of ingredients. Whatever combination of ingredients you choose in order to create the best tasting cocktail, the resulting libation will be limited to the 10 ounce level of your cocktail shaker. Likewise, if our portfolio has 10 units of risk that can be allocated among different asset classes, we construct the optimal combination of those different risk allocations (or ingredients) to produce the highest expected return for the portfolio while maintaining the level of overall portfolio risk.

To learn more about this approach to investing, and how you can incorporate it into your investment strategy, contact a Financial Advisor today.