Are your clients throwing their portfolios right out the window? That’s a pretty common complaint from advisors when markets crash into bear territory. Many advisory firms’ asset bases shrink as nervous clients suddenly decide that a mattress is the best repository for their cash during times of trouble.

Although it would be easy to lay the blame for asset drain at the clients’ doorsteps, the client may not be entirely at fault. In fact, it could be you. I know it’s sacrilege to say this, but advisors often acquiesce easily to a new client’s off-the-cuff wishes for portfolio construction when times are good — however mistaken they may be — as a simple way to gather assets. And that usually results in portfolios that fall outside a client’s true comfort zone, with predictable results when markets go on a wild roller-coaster ride.

Understanding the portfolio-building process will reassure you and your clients that the results will help them meet and even exceed their long-term financial goals.

A personalized portfolio is really the result of an investment process, which begins with the know-your-client questionnaire that we all make our clients fill out. Unfortunately, many advisors still see it as just another piece of bureaucracy. In truth, it’s the one piece of bureaucracy that has real value because it’s the one document that will drive the asset-mix decision appropriate for the client, the first layer of diversification within any portfolio.

Having established an asset mix, the next step is to select individual assets using a process that brings additional layers of diversification to a portfolio: bond quality and duration, for example, in the fixed-income portion; or geographical region or sector in the equities component.

These additional layers of diversification add two major benefits to the portfolio: one, they help reduce risk within the portfolio; two, they help make the portfolio more efficient. The litmus test for the process is really quite simple: does the portfolio produce better than average returns with lower than average risk?

I stress asset mix rather than individual securities selection in a client’s initial portfolio construction because of the importance that asset-mix decisions play in the portfolio’s overall return.

Studies have shown that 85%-90% of overall portfolio returns can be pegged to the asset-mix decision. Another 5%-10% of returns come from market-timing (shifting in and out of investments in response to economic changes). The remainder of your success, which is minimal, depends on selecting one specific security over another.

In other words, by determining which percentage of a client’s portfolio is committed to fixed-income assets, to equities and to any other asset class, you have laid the basis for at least 85% of the client’s total return. Presenting this package to a client rather than acquiescing to an unstructured hodge-podge of “hot” stocks can go a long way toward satisfying a client’s true risk tolerance levels — and thus increasing your chances of retaining assets when times get tough.

When markets experience extremes of volatility, many clients become anxious about their investments. There’s a tendency to demand that you “do something.” With the portfolio paradigm that we favour, you are relieved of the necessity of acting in panic, perhaps selling this, that or the other investment, which has already declined in value, thereby locking in the proverbial losses. The asset-allocation principle at the heart of the portfolio paradigm goes a long way toward resolving this problem.

There are two basic approaches to asset allocation: strategic asset allocation and tactical asset allocation. Here’s a closer look at the two:

> Strategic Asset Allocation is defined as a process of apportioning a client’s portfolio among the broad investment classes: cash and cash equivalents, income assets, equities (including international equities), real estate, alternative strategies and speculative assets.

Here’s the key — and the main reason why smart advisors take the KYC process seriously: the introduction of different types of securities, particularly those that are less than perfectly correlated, will reduce the variability of the portfolio and increase the likelihood that the portfolio will earn the required rate of return. During market turmoil, as we’ve seen this year, that can be the difference between retaining the client or losing the assets to a mattress.

When we talk about strategic asset allocation, we are talking about an investment philosophy in which you structure a portfolio based on your client’s personal investment objectives and risk tolerances. For most clients, the range of asset mix is somewhere between 30%/70% and 70%/30% fixed-income assets relative to equities, spanning from a growth to a conservative stance.

@page_break@Having established a strategic asset mix, the long-term management of the portfolio requires re-balancing the strategic mix back to mandate either on a specific date or as a result of specific variations within the asset classes. For example, if a balanced portfolio has become weighted 60% in fixed-income because the equities markets have crashed, we would sell bonds and buy equities to restore the 50%/50% balance.

This approach also works as an automatic check on the trap of market-timing by forcing an equities buy/sell decision based on portfolio mandate rather than the relative valuation of the market. But it also puts in place a discipline that forces the manager to sell high: for instance, sell assets that have recently outperformed and buy assets that have underperformed. The goal is always to rebalance back to the strategic asset mix.

> Tactical Asset Allocation follows a different track. With a tactical strategy, the manager’s focus is on weighting the portfolio to take maximum advantage of current market conditions. If, for example, the tactical manager believes that equities will outperform fixed-income over the next period — whether it’s a month, a quarter, six months or even a year — the manager would overweight equities and underweight bonds.

Sometimes, the tactical manager is constrained within a range of asset mixes. For instance, the equities mandate might be constrained to a weighting of between 30% and 80% of the total portfolio. In this case, even if the manager believes that equities will outperform, he or she cannot hold more than 80% of the portfolio in equities.

Some tactically managed assets have no constraints. The manager can weight the asset mix in any combination that he or she believes will provide the best risk-adjusted return for the next period.

That said, tactical asset allocation assumes you are able to take advantages of changing markets, which is obviously easier said than done. IE