Morningstar Magazine - June/July 2017 - 55

just purchasing a few mutual funds with good
potential future performance. In reality, there
are a number of important and complex decisions
that must be made. We explore these decisions
using a seven-question framework. The questions
should be considered in order.
Why Invest at All?
Investors and their advisors need to start with a
clear understanding of financial goals and how
they relate to each other. Goals justify saving, but
they also invite the advisor to devise the best
approach to meet each goal.
The best approach might mean financial planning
advice that swaps certain behaviors for
others. For example, one client might wish
to divert retirement savings to pay off credit card
debt, while another might forgo homeownership a
few years to save for retirement and take
advantage of a generous employer matching
contribution. But the best approach might also
involve how someone invests to meet a goal. That
could be choosing to save in a 529 plan to boost
tax savings, minimizing risk on savings earmarked
for a large purchase planned for next year, or
moving certain investments into passive vehicles
to cut costs. All of these decisions need to
be made holistically, with the characteristics
of the investor, investments, and goals in mind.
Which Type of Account Is Best for My Situation?
Two important and related decisions when
determining which account type to use are:
3 Selecting the optimal account type (for example,
a 529 account versus a taxable account to
save for college).
3 Investing the assets in a way that maximizes
tax efficiency (something commonly referred to as
asset location).

The account-type decision can be an important
way to increase savings by decreasing taxes.
This decision flows from goal-setting-there's no
single best account for all investors in all situations.

For example, if an investor is saving to fund
college expenses for a child, a 529 account can
offer tax-free contributions and provide tax-free
distributions for qualifying education expenses.
Asset location is a way to take the best advantage
of an investor's tax-sheltered accounts. This
is where investor-specific, cross-goal advice really
shines. For example, bonds-a core investment for
most investors-are relatively inefficient from
a tax perspective, but that doesn't matter if they
are held in a tax-advantaged account. So, instead
of holding multiasset portfolios in taxable and
tax-free accounts, higher-taxed investments should
go in sheltered accounts while other investments
go in taxable accounts. The advisor can
help the client invest across accounts holistically.
What Is the Appropriate Risk Level?
It's important to ensure a portfolio is consistent
with an investor's goals and risk-aversion
level. Regardless of how efficient a portfolio may
be (or, how well it maximizes expected return
for risk), it can't be the best portfolio for a
client if it is not consistent with the client's risk
appetite and does not fit his or her goals.
Determining the appropriate risk level is complex.
Today, risk aversion is commonly measured
through tools such as risk-tolerance questionnaires.
But these questionnaires generally focus on risk
preference, or how the investor feels about
taking risk, and not on risk capacity, or how much
the investor should take given his or her financial
situation. Another forgotten factor is the investor's
observed behavior in real or simulated scenarios.
The portfolio should address not only the
characteristics of the investor but also those of the
goals. An aggressive, well-heeled client might
be fine in an all-stock retirement portfolio.
But the sleeve of assets set aside to purchase a
vacation home next year should be invested
conservatively because of the horizon of that goal.
Which Asset Classes Should Be Included?
Portfolios are commonly constructed with asset

classes that have different risk characteristics,
such as domestic equities and international
equities. An investor uninformed on the benefits of
diversification may choose a simpler allocation
that is less efficient than it could be. For example,
an investor could choose to invest entirely
in domestic large-cap equities (for example, the
S&P 500 for a U.S. investor), or create a more
efficient portfolio by considering additional asset
classes such as domestic small-cap, international
equities, and emerging markets.
How Does the Risk of the Goal Affect How I Invest?
Goals are at the heart of the investment
decision process. Yet portfolio allocations are
usually determined using some type of
optimization routine that focuses entirely on the
risk of the assets (in this case, the asset class
opportunity set). This ignores the risks associated
with the goal itself.
In reality, the risks of the goal can (and should)
play an important role in the portfolio optimization.
For example, inflation is an important risk
for retirees who seek to generate inflation-adjusted
income for life. By incorporating the nature of
the liability into the portfolio optimization process,
it is possible to build portfolios that can better
hedge the risks faced by an investor. While these
"liability-driven" portfolios may appear to be
less-efficient asset allocations when viewed from
an asset-only perspective, they are more efficient
when it comes to achieving a goal.
What Investments Are Right to Help Me Reach
My Goal?
Once the asset-class targets have been determined,
an investor must then select investments.4
This includes decisions about individual managers,
strategies, active versus passive, and vehicles.
Given the difficulty of consistently selecting
funds that outperform peers on a risk-adjusted
basis, advisors who haven't adopted a proven
system to select active managers have in recent
decades focused on fees when building
client portfolios.5

4 It is probably better to determine the asset-class weights first and then investment allocations separately by considering the quality of the investments in the optimization routine; e.g., using some
type of alpha-tracking error optimization. This approach is relatively rare, though, among financial planners. See "A Primer on Factor Models and Portfolio Optimization, Part III" by Paul D. Kaplan on
Page 70-73 in this issue of Morningstar for information on this approach.
5 Because past performance is no guarantee of future results.

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