The quest for the elusive perfect portfolio is never-ending for those who construct or choose portfolios for clients.

The active or passive decision is passionately discussed.

And advisers also grapple with decisions, such as whether to use packaged products or individual securities; include just a few or many asset classes and in what proportion; and rebalance frequently or seldom.

There are a few absolutes one needs to keep in mind, and portfolio management is more art than science because the world is always changing. So the highest value to clients is choosing a philosophy and methodology that help them reach their financial goals and keep their behavior in check.

My investment-related beliefs have come from personally managing money during three market bubbles (Japanese economy, and U.S. housing/derivatives) and the three bear markets that followed their collapse.

These experiences influenced me to form two core beliefs:

1. The markets are efficient except when they aren’t

2. There are periods of time when securities and entire markets become significantly mispriced.

Investment managers can take advantage of buying opportunities when the best companies or sectors of the markets become grossly mispriced. This shouldn’t be confused, by the way, with purchasing a bad asset just because it is cheap.

My core beliefs led to a few additional supporting beliefs:

3. Over time, it is more important to prevent large portfolio losses than maximize gains.

4. Inexpensive, passive portfolios can often beat the vast majority of actively managed portfolios by low fees alone.

5. However, the exception to number two is a very small group of money managers who are the very best at their craft. These top performers exist for every skill in life. They may be athletes, chefs, artists, writers, musicians and yes, investment managers. The very best investment managers were born with the ability to be among the elite, and over the intermediate to long term, have proven that they can consistently beat the returns of an inexpensive passive portfolio.

Anyone interested in exploring number three further should at a minimum read the Preface of the book Market Wizards Updated: Interviews with Top Traders, 2012 (which can be read as a “Look Inside” on Amazon) to get a sense of the extent of skillsets people with this type of ability possess.

Our firm had to decide how to incorporate my beliefs into our approach to portfolio management. We chose to use a core/satellite portfolio construction for clients.

Our core allocation is part passive and part active. We are outsourcing the active piece to a combination of elite investment managers with long track records, and we are using low-cost index ETFs and mutual funds for the passive piece.

The core represents 65% to 85% of the client’s portfolio, depending on the client’s risk profile and time horizon. The other 15% to 35% of funds are invested in the satellite portion of our portfolios.

The satellite portfolio is opportunistic and typically contains individual equities, bonds and ETFs to augment the core portfolio. They are designed to complement the core by boosting growth or protection over the intermediate to long term.

Although our investment management capabilities can’t compete with the top investment managers, it isn’t difficult to recognize when certain high-quality securities have sold off to the extreme where they are mispriced relative to their intrinsic value. We are willing to buy some of them cheap and wait for them to become more fairly valued.

Purchasing mispriced securities with a strict stop loss strategy in place for minimizing losses has allowed us to achieve a higher average return over time than a core-only allocated portfolio. In fact, during times when we believe significant market risk exists, the satellite in many cases has allowed us to reduce the down-side risk of the two portfolios combined while maintaining an appropriate blended expected return that would be consistent with the normal risk profile of the core alone.

For example, by adding the opportunistic satellite portfolio, we can dial down a growth core portfolio to balanced, with little to no loss in return during times of greater than normal market risk. The more conservative core allocation has helped us reduce losses during market corrections, an especially effective strategy for increasing long-term returns.

Additional satellites can also be used as a strategy for mitigating other types of risk due to changes in investment cycles. For example, because when very low interest rates end, bond mutual funds and ETFs will typically decline in value as rates rise.

One strategy we are using to mitigate this type of loss is adding a satellite portfolio of laddered individual intermediate-term insured, callable municipal bonds with yields of 4 to 5%. We purchase each bond planning to hold it to maturity.

A good bond shop assists with the appropriate bond selections.

A well-diversified passive or combination passive/active core portfolio paired with one or more satellite portfolios comprising carefully chosen high-quality opportunistic securities with minimal downside risk may prove to be just what the doctor ordered during these uncertain times.

This story is part of a 30-30 series on ways to build a better portfolio.

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