Many finance practitioners and especially theorists seem to be in search of objective, repeatable right and wrong answers for how to invest. They want to apply the linear, codified thinking of disciplines like math and physics to the human, organic activity of investing. Where basic math and physics present problems where the solution is either correct or incorrect, finance presents wicked problems.
Wicked problems are ones where many solutions are possible. As an example, choosing an outfit to wear is a wicked problem. Some outfits are more appropriate than others, but there’s no right or wrong solution. Going to a high class restaurant for dinner would suggest a different solution than going dancing or working in the yard. In each case, finding the best outfit means taking into consideration the purpose, your own values and your preferences.
Portfolio design works much the same way. First, you (or your advisor) must understand your purpose. If you’re accumulating wealth, the tools you will use will likely be very different than if you need to produce income. Next, you must be clear about your values. If you don’t want to include tobacco stocks or oil producers, that must be clear up front. Most investors that I’ve encountered, however, have few qualms about how they earn a return. Finally, be clear about your preferences. If price fluctuations keep you up at night, either more stable investments or a blended approach might work better. If you want each spouse’s portfolio to match, that can be accommodated.
As an aside, this is why I can’t abide columnists and bloggers who argue that only ETFs are right, and mutual funds are always wrong. Or bonds are necessary or real estate is too risky. In reality, some ETFs may be appropriate for your purpose, but others may not. Or mutual funds may be the best solution, given your present circumstances.
Finally, portfolio design works within certain constraints. Time is a consideration when your goal is time-bound, such as “retire at age 60.” Taxes are a constraint because they can impact the efficient growth of the portfolio; costs and fees are a constraint in a similar way. The frequency of deposits and withdrawals is also a constraint.
Designing an effective investment portfolio is both an art and a science. The science is understanding how the tools work and why. The art, however, is understanding the individual purpose, the personal values and preferences and the particular constraints that exist. There is no correct solution, as such, but there are portfolios that are more appropriate for a given investor and his or her personal situation.