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What Are Model Portfolios and Are They Right for You?

Should you use a model portfolio?

Whether you’re a new or veteran investor, you probably want a lot of different things from an investment. But, deciding which investments will help you achieve your financial goals may be a bit of a challenge. So, rather than putting together a portfolio of investments from scratch, many financial advisors will assign you to a pre-built model portfolio. Here’s what to expect from a model portfolio and what to consider when selecting one. However, you can also work with a financial advisor to determine if this is the right strategy to help you reach your financial goals.

Model Portfolios Explained

Investing comes with expectations. Many investors, for example, may seek high returns, low risk, tax efficiency and perhaps even social status. This has created a need for investors to feel like they understand the direction of their overall portfolio. So, financial advisors have started to assemble model portfolios for investors to illustrate how they will achieve their overall financial and portfolio goals.

Model portfolios are a diversified group of assets designed to achieve an expected return with the corresponding risk. Ideally, each portfolio has a combination of managed investments based on extensive research. These portfolios blend asset classes, investment managers and investment strategies to achieve diversification.

Typically, financial advisors or investment managers offer a variety of portfolios to correspond with your financial goals and objectives. Model portfolios allow investors to use simple and effective investment methods that require minimal management effort. Model portfolios can free up a financial advisor to focus on financial or tax planning without giving up total portfolio control.

Advantages of Investing in a Model Portfolio

Should you use a model portfolio?

There are several advantages to investing in a model portfolio. Here are a few benefits you should consider when determining if this is the right investment choice for your financial goals and objectives.

1. Diversification 

A model portfolio allows you to diversify your assets. Diversification is an investment strategy that helps investors reduce risk by distributing funds across multiple financial vehicles, asset categories and industries. To maximize returns while reducing risk exposure, financial advisors select investments that may react in different ways when the same event occurs.

For instance, let’s say you decide to invest in railroad stocks. Then railroad workers go on strike and stock prices plummet. This scenario would cause your portfolio to take a severe hit. However, if you also invested in airline stocks, you may see an increase in share prices as people fly instead of taking trains. But, it could also have a negative impact on this stock because both are in the transportation industry. So, in an ideal scenario, you want to invest in a wide variety of securities in different industries to avoid a big loss when an event, such as our imagined railroad strike, occurs.

2. Research and Professional Analysis 

Another advantage of investing in a model portfolio is that knowledgeable experts in the industry probably designed them. Most financial advisors and investment managers use their professional analysis and extensive research to create detailed investment strategies and philosophies before selecting the assets for each portfolio. This means that they have put in place a clear review process for assessing each investment in the portfolio and will evaluate its individual performance on an ongoing basis.

3. Rebalancing 

Most investment advisors monitor and review their model portfolio to ensure it is meeting their benchmarks and performing at an acceptable level. Part of this process involves rebalancing each portfolio. By rebalancing your portfolio you readjust the percentage of the portfolio that’s invested in each asset. This process involves the period of buying and selling off assets in a portfolio. It helps maintain the designated asset allocation.

For instance, let’s say the model portfolio’s desired asset allocation was 40% stocks and 60% bonds. If the bonds perform well, it may increase the allocation percentage to 70%. They would then need to sell some bonds and buy additional stocks to get back to the targeted allocation. By rebalancing financial advisors can maintain the right level of risk exposure.

4. Affordability

Model portfolios can be much more affordable than investing in comparable mutual funds or exchange-traded funds where the advisor has no ability to make investment decisions. This is especially true with any actively managed fund that you choose to invest in. The low costs of model portfolios are one of the biggest advantages, especially if they meet the demands of the investor. It should be noted, however, that a model portfolio that uses an actively managed mutual fund may have comparable costs to investing in that mutual fund directly.

Disadvantages of Investing in a Model Portfolio

Should you use a model portfolio?

When you commit to a model portfolio, you lose some control of your asset management. If you feel uncomfortable handing over complete control of your money to a financial advisor, a model portfolio may not be the way to go.

Additionally, like all other investments, performance is never guaranteed. Even though model portfolios are under professional management, that doesn’t mean that they will perform. Even the best money managers can lose money in a slumping market.

A model portfolio can also include additional fees that wouldn’t be there if you chose your own investments. Often, because of the investment selection, it’s hard to determine the exact amount you’re paying. So, if you do decide to invest in a model portfolio, make sure you understand the cost as well as the financial advisor’s fee structure. However, these costs might be countered by an increase in portfolio return.

How to Choose a Model Portfolio

Model portfolios are offered by strategists and asset managers. The asset managers have lower fees, typically, because they also receive fees directly from the fund itself. The strategies are typically registered financial advisors who may charge an additional strategist fee because they are creating the overall investment decisions for the portfolio.

Model portfolios come in a variety of styles or specific types of focus and you should select one that meets your financial goals. For example, some target income while others target risk. It’s important to find a model portfolio that aligns with your investment goals and that is offered by a registered advisory firm that oversees the portfolio. Ultimately, the choice of a model portfolio is individualized to each investor.

The Bottom Line

Model portfolios can be great options for investors who don’t want to take the DIY approach to investing. But before you invest your hard-earned money into a model portfolio, it’s important to understand how the portfolio works. You will also want to compare fees. The more knowledgeable you are, the better investment decisions you will make.

Investment Tips

  • A financial advisor can walk you through a model portfolio and they can also help determine if it’s the right fit for your investing style. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you are still a little apprehensive about using a model portfolio, you can start with a little investment and see how it performs. You might want to consider starting with a robo-advisor. TIt’s an online tool that offers lower fees and lower account minimums than traditional advisors. Since model portfolios require minimal effort and thought on your behalf, they may be what you need to keep your peace of mind.
  • It’s hard to put together a portfolio of any kind if you don’t know how much you’re investing or how much risk you’re willing to take. SmartAsset’s investing guide can answer some of those questions and let you know how taxes and inflation will affect your investment.

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