Summer Reading: Portfolio 'Ingredients'

Excerpted with permission of the publisher John Wiley & Sons, Inc.(www.wiley.com ) from 7Twelve: A Diversified Investment Portfolio with a Plan by Craig L. Israelsen. Copyright (c) 2010 by Craig L. Israelsen.

By Craig L. Israelsen

The 7Twelve portfolio is a completely strategic portfolio design. Strategic portfolios are built and managed by following preset guidelines that are not affected by whim, opinion or market gyrations. A strategic portfolio is often viewed as a more "passive" approach to investing because it does not imply, or rely upon, skill or market timing. Rather, a strategic portfolio relies upon commitment to the recipe and adherence to the preset guidelines. Strategic portfolios set a course and follow it.

The opposite of strategic is tactical. A tactical portfolio is much more dependent on skill, opinion and luck. A tactical portfolio has a flexible set of guidelines that can change based on market conditions or opinions of the manager. A tactical portfolio may change course at any time.

As a strategic portfolio, the 7Twelve recipe follows three simple guidelines:

1.Select 12 different "ingredients" or mutual funds
2.Equally weight the ingredients
3.Rebalance periodically

Each of the 12 mutual funds in the 7Twelve portfolio is assigned an equal allocation of 8.33%. The 7Twelve portfolio includes eight equity-based mutual funds that create an overall equity (stock) allocation of approximately 65% equity (66.6% to be exact). Four fixed income funds create a total fixed income (bond) allocation of about 35% (33.3% to be precise).

With a 65% equity/35% fixed income asset allocation model, the 7Twelve can be categorized as a "balanced" portfolio because it has an overall asset allocation model that conforms to the general 60% stock/40% bond template. However, the 7Twelve portfolio is much more diversified than the typical 60/40 balanced portfolio.

The 7Twelve design and asset allocation model does not change based on market conditions. The performance of the 7Twelve is, of course, affected by the performance of its 12 underlying investments, but the recipe does not change based upon the behavior of investment markets. Some people refer to this type of portfolio design as a "passive" approach. It rewards investors who exercise patience in following the recipe and who do not attempt to "overmanage" the portfolio.

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Investment portfolios that are actively changing based on market conditions are referred to as tactical portfolios. Tactical portfolios ultimately rely upon the skill of the portfolio manager to react appropriately to changing market conditions. A tactical portfolio would, for example, be much less likely to equally weight the ingredients of the portfolio. Moreover, a tactical portfolio will tend to overweight or underweight various portfolio components at the discretion of the portfolio manager. If the manager is correct, the portfolio wins. If wrong, the portfolio loses. It's all based on skill, and skill is actually very hard to find. Tactical portfolios are referred to as an "active" portfolio management paradigm.