Effective Model Portfolio Construction: A Guide for Retail Investors and Advisors

However, a simple set of four basic rules from asset manager State Street can help build a successful model portfolio for clients or retail investors.

For advisors or anyone looking to build a steady model portfolio, having a simple framework increases the odds of success. And in that, outcomes can actually be realized.

By its basic definition, a model portfolio is simply a collection of assets and investments designed to meet end goals. They can serve as a framework for asset allocation and diversification. They are most effective when followed via a hands-off and rebalancing approach. This allows the model to work its magic and match risk tolerances and timelines.

But for many retail investors—and advisors for that matter—building a model portfolio can seem complex. There are hundreds of bond varieties, numerous stock factors and sectors, and plenty of alternatives like real estate or precious metals to consider when building a model portfolio.

To that end, construction of an effective one often takes a back seat to simply saving. Investors end up with a collection of assets and funds that don’t necessarily mesh well together. That’s a recipe for disaster.

But there is a simple way to build a great model portfolio. By starting with a solid core foundation of stocks and bonds, expanding outward, customizing, keeping cost low, and being disciplined with rebalancing, investors and advisors can craft a top-notch model for investment.

When investors or advisors first begin constructing their model, a solid core is key. This collection of assets will form the base and foundation that everything else is built upon. And the secret to a good core portfolio is to think broad.

While active management has grown in popularity in recent quarters thanks to the surge in active ETFs, there is something to be said for indexing and passive investment, particularly when it comes to your core portfolio. By using index funds, investors can simply own the entire market. In addition to thinking broadly within asset classes, thinking broadly for their core can work among different asset classes and regions.

According to asset manager State Street, thinking broadly among regions and asset classes pays big benefits when it comes to limiting losses. Just check out this chart showing how different indexes perform alongside a basic 60/40 bond split.

Source: State Street

That is the real benefit in thinking broadly. By owning a variety of stocks and bonds, investors can limit their downsides. When one asset class zigs, another can zag.

Once investors have a solid core of stocks and bonds that are broad, it’s time to dig in and customize to needs. This is based on risk tolerance, return expectations, and time horizon.

Generally speaking, the younger you are and the longer you have until you need to tap your portfolio, the more aggressive you can be. This means riskier asset classes like stocks. For an investor in retirement, bonds and a more conservative approach can work well. But keep in mind, just because a client or investor is younger doesn’t necessarily mean that they can stomach the market’s ups and downs. If volatility is keeping them up at night, a different and less risky approach may be warranted.

This comes into play when looking at returns versus standard deviations. For example, an aggressive portfolio has managed to return around 8.3% annually over the last 20 years. However, it’s managed to produce a 20-year annual standard deviation of about 13.9. That means it’s moved around quite a bit to make its returns. Conversely, a conservative portfolio has returned about 4.5%, while only bouncing around 5.0 in terms of standard deviation.

This is where advisors can add outside asset classes to suit needs as well. Investors looking for more income can add additional bond types like preferred stocks or high yield bonds, while investors looking for capital gains can focus on stock sectors. However, keep this within the framework of risk tolerance and timeline.

What you keep is sometimes more important than what you earn. Taxes and expenses can erode even the best laid portfolio and plans. That’s why limiting taxes and choosing low-cost investments are best. All things being equal, when comparing two funds that track the same index, the lower cost one will outperform. Even if that outperformance is just a few basis points, over time that compounding can matter.

The average U.S.-listed mutual fund had an expense ratio of 0.98% at the start of 2024 and averaged a 7% annual return over the last decade. When looking at starting principal, investors would have paid a cumulative 9.8% in fees. Putting that into perspective, that’s nearly 3% more than an entire year’s worth of returns over a decade.

The advice is easy. Find the lowest cost investments you can.

Model portfolios only work if they are followed. There is no point in setting up a portfolio only to buy and sell whatever fits your fancy. For investors, this means managing a model through systematic and disciplined portfolio rebalancing is key. Selling winners to buy losers or adding new money to down asset classes to keep allocations within ranges is critical.

For example, buying the S&P Composite 1500 Index at the beginning of 2003 at a 40% portfolio allocation and holding it for 20 years would have increased the allocation in the portfolio to 58%. Moreover, it would have boosted the portfolio’s standard deviation of returns by over 2%, creating bigger drawdowns and higher volatility of returns.

Rebalancing a portfolio is critical to keeping a model successful.

These ETFs are sorted by their YTD total return, which ranges from 2.4% to 15.8%. They have AUM between $5.5B to $378B and expenses run between 0.03% and 0.18%. They are currently yielding between 1.3% and 3.8%.

In the end, building a model portfolio does not have to be hard. Selecting broad funds covering a wide range of asset classes, keeping allocations within risk tolerances, and understanding how rebalancing and costs play into returns are all keys to success.

Building a successful model portfolio is key to realizing and meeting end goals. and yet so many advisors and investors have trouble doing just that. In reality, it’s easy. Following the aforementioned four simple ideas can provide a great framework for model portfolio success.

¹ State Street (June 2024). Core Portfolio Construction Principles