A model portfolio is a basket of holdings – cash, fixed income and equities – an advisor combines to achieve an investment objective or risk tolerance level.
Not every adviser uses a model portfolio approach.
The ones that do will often have more than one model portfolio to reflect the appropriate investment objectives and risk tolerance of each person. Objectives are usually classified as income, long-term growth, and short-term growth. Risk tolerance may be as simple as low, medium and high. Investment objectives and risk tolerance help establish which model portfolio is most suitable.
Our model portfolio approach includes three different broad options – income, income and growth, and growth. The best way to illustrate this is to use the situations of three individuals. John, Wendy and Alex each have $500,000 to invest and fall into a different model portfolio. The chart below summarizes the asset mix and number of equity holdings within each model.
- John was referred by his accountant. He is 60, recently retired and withdrew the commuted value from his pension plan, valued at $500,000. In listening to John’s investment objectives and risk tolerance, it was clear the income model portfolio was the most appropriate for his needs. He did not have a lot of experience with investing and was nervous about investing too much in the stock market. He also wanted to immediately withdraw a monthly amount from the account to live on. The income model portfolio would have an optimal asset mix of 60 per cent fixed income and 40 per cent equities. The fixed income would have a larger short-term component to meet his cash flow needs. Within the equity portion, the number of individual companies John would acquire is 20 and the targeted position size is $10,000 per company. These 20 equities would all be large blue-chip equities, diversified by sector, and that pay dividend income. We were able to give John an estimated income report for the income model portfolio along with a discussion regarding risk and reward.
- Wendy recently received an insurance payout of $500,000 from an accident she was in three years ago. She is 50 and planning to work for the next 10 to 15 years. It was apparent the income and growth portfolio was most suitable. Given that Wendy was moderately comfortable with assuming risk, her portfolio would have 40 per cent in fixed income and 60 per cent in equities. The number of individual companies Wendy would own is 25 and the targeted position size is $12,000 per company. These would be large companies that have both growth and income components. Wendy did not require immediate income, so we set up the dividend reinvestment plan on the equities she will be holding longer term.
- Alex sold his shares in a private technology company and netted $500,000 after tax. He’s 40 and looking for tax-efficient growth and is comfortable assuming more risk to achieve greater long-term rewards. The growth portfolio is the most suitable for Alex and has only 20 per cent in fixed income and 80 per cent in equities. The number of individual companies Alex would own is 30 and the targeted position size is $13,333 per company.
Model portfolios help new clients understand the total investment costs, income, sector weighting, and structure like the number of holdings and position size.
Without these models it can be difficult for people new investors to visualize how their money can work best for them. The ranges shown above are important as it allows customization for each client.
If an investor wishes to invest in something that is not within the model portfolio, it is still be possible. We establish ranges outside of the optimal position size. For example, if a person transfers in a large position from an employer they may purposely want to overweight that name and have a greater position size than the optimal amount.
Another example is a person who has large gains on some stocks and wishes to continue overweighting them.
Some investors may wish to purchase investments that are not within a model portfolio. The ranges above usually provide flexibility to do this. A person may phone us for an unsolicited trade to purchase small companies or emerging markets which may not be part of any model. Or a person who chooses to overweight a particular sector which can also increase the risk of a portfolio.
Models help set the parameters for the portfolio within reasonable ranges while still allowing customization for each client. It assists an advisor in establishing a methodology to manage and explain risk and reward. By comparing all three models, new clients can work with advisors to select the portfolio that they feel best reflects their wishes.