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When you hire a financial advisor to manage your portfolio, one of the first questions you might ask is: How do you choose investments? Understanding an advisor's investment selection process helps you evaluate whether their approach aligns with your goals, risk tolerance, and philosophy.
The answer varies dramatically depending on the advisor's investment philosophy, but there are common frameworks and criteria that most advisors use. Here's what goes into building and managing a portfolio—and what you should expect from your advisor.
The Foundation: Understanding Your Situation
Before selecting any investments, a good advisor starts by understanding you:
Goals and Timeline
What are you investing for? Retirement in 30 years requires a different strategy than a home purchase in 5 years. Your timeline determines how much risk you can afford to take and what asset allocation is appropriate.
Risk Tolerance
Can you stomach a 30% decline without panicking and selling? Or would a 10% drop keep you up at night? Your emotional and financial ability to handle volatility shapes your portfolio's construction.
Current Financial Situation
Your income, expenses, emergency fund, debt levels, and other assets all influence investment decisions. If you own a business or significant real estate, your portfolio should be constructed differently than someone with only investment accounts.
Tax Situation
Are you investing in tax-advantaged retirement accounts or taxable accounts? Your tax bracket and future income expectations determine whether to prioritize growth, income, municipal bonds, or tax-loss harvesting strategies.
Only after understanding these factors does the advisor move to investment selection.
Asset Allocation: The Most Important Decision
Academic research shows that asset allocation—the mix of stocks, bonds, and other assets—determines over 90% of a portfolio's variability in returns. This decision matters far more than which specific funds or stocks you own.
Advisors typically determine asset allocation by:
- Your age and timeline to goals
- Your risk tolerance and capacity
- Historical risk/return data for different asset classes
- Current market conditions and valuations (for some advisors)
A 35-year-old with high risk tolerance might have 90% stocks and 10% bonds. A 65-year-old retiree might have 50% stocks, 40% bonds, and 10% cash.
Investment Selection Approaches
Once asset allocation is determined, advisors use different approaches to select specific investments:
Passive Indexing
Many advisors—especially fee-only fiduciaries—use low-cost index funds or ETFs to implement the asset allocation. This approach emphasizes:
- Broad diversification across thousands of securities
- Minimal costs (expense ratios below 0.10%)
- Tax efficiency
- Evidence-based investing grounded in academic research
A typical passive portfolio might include:
- Total U.S. stock market index fund
- Total international stock market index fund
- Total bond market index fund
Adjustments are made by changing the percentages allocated to each, not by picking individual securities.
Active Management
Some advisors believe they can outperform the market by selecting individual stocks, timing sectors, or choosing actively managed funds. They evaluate:
- Company fundamentals (earnings, revenue growth, balance sheets)
- Valuation metrics (P/E ratios, price-to-book, etc.)
- Economic trends and market cycles
- Manager track records and investment processes
Active management comes with higher costs and mixed evidence on whether it delivers better after-fee returns. Research shows that very few actively managed funds consistently outperform low-cost index alternatives over long periods.
Factor-Based Investing
Some advisors tilt portfolios toward factors that historically deliver higher returns: value stocks, small-cap stocks, profitability, momentum, or quality. This approach falls between passive indexing and active stock-picking.
Factor-based strategies use systematic rules rather than subjective judgment, aiming to capture premiums that academic research suggests exist over time.
Tactical Asset Allocation
Some advisors adjust asset allocation based on market conditions, valuations, or economic outlook. For example, they might reduce stock exposure when they believe markets are overvalued or increase it when opportunities appear attractive.
This approach requires correctly predicting market movements—something that's notoriously difficult even for professionals.
Criteria Advisors Use to Evaluate Investments
Regardless of approach, advisors typically evaluate investments based on:
Cost
Lower expense ratios mean more of your return stays in your pocket. Good advisors prioritize low-cost investments unless there's compelling reason to pay more.
Diversification
Investments should reduce concentration risk, not increase it. Advisors avoid putting too much in any single security, sector, or geography.
Tax Efficiency
For taxable accounts, advisors favor investments with low turnover, minimal capital gains distributions, and tax-loss harvesting opportunities.
Liquidity
Can you access your money when needed? Advisors avoid illiquid or hard-to-sell investments unless there's a specific reason.
Risk-Adjusted Returns
It's not just about high returns—it's about returns relative to risk taken. Advisors evaluate whether an investment's potential return justifies its volatility.
Fit Within Overall Portfolio
Each investment should play a role. Advisors consider how it interacts with other holdings and whether it improves the portfolio's overall risk/return profile.
How Advisors Construct Portfolios
Core-Satellite
A "core" of low-cost index funds provides broad exposure, while "satellite" positions in specific sectors, strategies, or actively managed funds offer targeted opportunities. This balances cost-efficiency with active management where it might add value.
Risk Parity
Some advisors balance risk contributions from different asset classes rather than allocating by dollar amounts. Bonds receive higher allocations because they're less volatile, creating a more balanced risk profile.
Goal-Based Segmentation
Advisors might create separate "buckets" for different goals: short-term needs in cash, medium-term in bonds, long-term in stocks. Each bucket is managed according to its timeline.
Ongoing Management and Adjustments
Investment selection isn't a one-time event. Advisors continuously:
Rebalance
When stocks outperform and grow beyond their target allocation, advisors trim gains and buy underweighted assets. This maintains your risk profile and enforces "buy low, sell high" discipline.
Tax-Loss Harvest
In taxable accounts, advisors sell investments at a loss to offset gains elsewhere, reducing your tax bill while maintaining exposure.
Monitor and Replace
If a fund's expense ratio increases, its manager changes, or its strategy drifts, advisors may replace it with a better alternative.
Adjust for Life Changes
As you age, your risk tolerance changes, or goals shift, advisors adjust the portfolio accordingly.
Questions to Ask Your Advisor
Understanding your advisor's investment selection process helps you evaluate whether their approach fits your preferences:
- What's your investment philosophy? (Passive indexing, active management, factor-based, tactical?)
- How do you determine asset allocation?
- What criteria do you use to select specific investments?
- How often do you rebalance, and what triggers rebalancing?
- What do you charge, and what are the expense ratios of the funds you recommend?
- How do you incorporate tax efficiency into portfolio management?
- Can you show me historical performance net of fees?
- How do you avoid conflicts of interest? (Are you a fiduciary? Do you earn commissions?)
Red Flags to Watch For
- Advisors who claim they can consistently beat the market
- High-cost actively managed funds without clear justification
- Complex products you don't understand (structured notes, non-traded REITs, variable annuities)
- Frequent trading without clear rationale
- Investments that earn the advisor commissions
- Lack of transparency about fees or selection criteria
Your Next Step
The best investment selection process is one that's transparent, evidence-based, low-cost, tax-efficient, and aligned with your goals. Whether your advisor uses passive indexing, active management, or a hybrid approach matters less than whether they can clearly explain their rationale and demonstrate that their process serves your best interests.
If you want to work with an advisor who prioritizes low-cost, diversified, tax-efficient portfolios and acts as a fiduciary, Chesapeake Financial Planners can help. We provide transparent investment strategies designed to maximize your after-tax, after-fee returns.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor and separate entity from LPL Financial.
Chesapeake Financial Planners | 2402 Scotlon Ct, Forest Hill, MD 21050 | (410) 652-7868 | www.chesapeakefp.com