A great deal of research shows that mutual funds outperform the accounts of investors who are investing in those mutual funds.[1]  This is due to the timing of investors’ decisions.  Investors are human and subject to emotional decisions, often investing in a fund after a period of great performance or exiting a fund after a period of poor performance.  Human decision-making is subject to a number of behavioral biases which can impact actual realized investment performance.  One way of minimizing the impact of these types of factors on investment returns is to have a disciplined investment process. 

A disciplined process is strategic and can minimize the tendency to make emotional decisions.  A disciplined process is also based on principles of investing that have been known to work and consider where the greatest sources of investment return and risk come from.  For example, research also shows that the greatest variability in investor returns comes from the asset allocation decision.  The classic study of Brinson, Hood and Beebower showed that over 90% of the variability or returns came from the strategic asset allocation decision, investment selection accounted for about 4% and tactical asset allocation about 2%.[2]  Subsequent studies refined this work.  Xiong, Ibbotson, Idzorek and Chen[3] showed that market movement had the greatest impact on returns, followed by strategic asset allocation and active management in close proximity.  It is clear from all of the studies that the most important factor in investing is simply to be invested.  We could debate nuances of which of the other decisions (strategic asset allocation, tactical asset allocation, investment selection) are the most important.  However, they are all important and contribute to an investor’s ultimate investment performance.  Fortunately, a disciplined investment process ensures that all of these important decisions are included and implemented in a strategic manner.

There are eight basic steps in the investment process as depicted below[4]. The process begins with gaining an understanding of the client’s (investor’s) needs, wants, preferences and constraints.  Next, the manager or advisor needs to assess what is happening in the economy and investments markets and what might happen in the future.  Note that this step could just as logically occur before client assessment and often does as investment advisors are assessing the economy and markets for the benefit of all of their clients.  I prefer this order, however, to remind readers that the client always comes first.  Additionally, the advisor should assess the economy and the markets with respect to the client’s situation.  The next step asset allocation – how much of a portfolio should be invested in different types (and or sub-types) of investments.  Some advisors may split this step into two steps – Strategic Asset Allocation and Tactical Asset Allocation.  Strategic asset allocation is long term in nature – typically a target for one or more years.  Some advisors may consider an optional step of tactical asset allocation – short term adjustments to the longer-term strategic allocation. 

A step commonly excluded from the investment process is asset location.  Investors often have different types of investment accounts, for example retirement accounts which are tax deferred and taxable investment accounts for which taxes are paid annually.  An important consideration today is which asset types should be in which type of account to maximize long-term after-tax investment returns.  Once we know how much of an investor’s portfolio will be invested in each asset type and account type, we need to decide on which securities, funds or managers to invest in.  Once the plan is implemented with the asset allocation in place and underlying investments selected, we need to continuously monitor and evaluate the underlying investments to make sure they are meeting our objectives.  If they are not meeting objectives, changes are to be made.  Different types of investments will perform differently and result in the actual asset allocation straying from the target asset allocation.  Periodically, the portfolio is rebalanced to bring it back in line with the target.  This stage might also include other adjustments to maximize after-tax performance on a periodic basis such as tax loss harvesting.  The process is continuous with periodic re-assessment of the client, economy and markets followed by reconsideration of the target asset allocation. Further details can be found in our Investment Process whitepaper under resources.

[1] For example, Amy C. Arnott, “Why Fund Returns are Lower Than You Might Think,”  Morningstar.com, August 30, 2021.

[2] Gary Brinson, Randolph Hood and Gilbert Beebower,“Determinants of Portfolio Performance,” Financial Analysts Journal, July-August 1986.

[3] James Xiong, Roger Ibbotson, Thomas Idzorek and Peng Chen, “The Equal Importance of Asset Allocation and Asset Management, Financial Analysts Journal 2010.

[4] Adapted and improved from Tools and Techniques of Investment Planning, 3rd Edition, Leimberg, Doyle, Robinson & Johnson, 2013.

A Disciplined Investment Process