What Does it Mean to Seek Optimal Investment Solutions?
Too often investment plans and investment management are done without consideration of all of the factors that influence the successful obtainment of your investment goals. We use the term optimal investment solutions to refer to the effort to identity and integrate all the factors that influence the obtainment of your goals into investment plans and investment management. Listed below are some of the factors that may need to be considered.
- Multiple Goals. Usually, you have multiple goals: college, retirement, etc. Each goal will have a different investment plan-and often tradeoffs must be identified and resolved between the various goals.
- Target Risk/Return Preferences. Your unique preferences need to be identified and followed.
- Time horizon. Each of your goals has a corresponding time horizon. Accurately defining the time horizon is very important to the optimization effort.
- Risk management. Risks include not just investment volatility, but other risks that will effect your investment plans-such as unexpected unemployment, unexpected health care costs, changes in the inflation rate, etc. Ways of modeling risk and managing risk need to be addressed.
- Optimal asset class allocations. Selecting asset class allocations associated with your goals is of great importance in determining investment results. Examples of asset classes are cash equivalents, large capitalization equities, corporate bonds, and municipal bonds.
- Industry sector allocations. Sectors tend to go through cycles of being "in favor" and "out of favor". It is important to define, and then adjust over time, sector allocations. Examples of sectors are health care, utilities, basic materials, and consumer products.
- Security selections. At the lowest level, all portfolios consist of a collection of individual securities. Selection of specific securities will have a major influence on investment results.
- Account type allocations. You may be eligible to contribute to various types of accounts such as tax-free, tax deferred, and taxable. The choice of how to allocate your savings between these types of accounts also has a major influence on your long-term after-tax results. The sequence of how you later withdraw money from these accounts is also important.
- Wasted investment expenses. Some investment expenses do not increase return or reduce risk. To obtain optimal results, wasted expenses must be minimized.
- Liquidity needs. You will have planned and unplanned needs for cash. Thus, how quickly and efficiently you can convert investment assets into usable cash needs to be looked at.
- Home ownership. For most families, their home is a significant portion of their net worth. The role of home equity as part of an investment plan needs to be assessed.
- International investing. Investment opportunities exist outside the US. The role of international securities should be assessed.
- Transaction costs. Transaction costs are necessary, but need to be kept low because they do not increase returns or reduce risk.
- Optimization of after-tax returns. After-tax returns are influenced by the account type, and also by issues such as capital gains versus ordinary income, short-term vs. long term capital gains, parent's tax rates vs. children's tax rates, pre-retirement tax rates vs. post-retirement tax rates, etc. How tax issues are managed will have a major impact on the success of your investment plan.
- Portfolio re-balancing and mix changes. Over time, your portfolio will deviate from the asset class mix established for your target risk/return. In addition, circumstances may change that require a change in the target asset class mix.
- Transition plan. Care must be taken on how to transition from your current investment position to the recommended one. Otherwise you may face extra taxes and transaction costs.
- Analytical techniques. Various analytical techniques should be used to assess some of the factors identified above. These include (a) efficient portfolio calculations that use the historical and projected characteristics of asset classes to estimate an optimal portfolio for a given target risk/return, (b) constant $ projections that use future projections of inflation to convert future projected account balances into today's dollars, (c) tax-free vs. tax-deferred vs taxable return comparisons to analyze the impact of income taxes, (d) simulations using the theories of sampling, probability distributions, and statistics to make projections, under conditions of uncertainty, to place upper and lower bounds on future investment returns and account balances, and (e) intrinsic value calculations that seek to identify mispriced securities.