Financial advisors are charged with choosing the best investments for their clients. So how does the advisor wade through the thousands of available products and construct a portfolio that’s right for you?

First Step: Assessing Risk

Almost all advisors start from a similar point. Portfolio selection is implemented after the advisor determines a client’s risk tolerance. In other words, how will the client feel and react in the event that their investment portfolio drops in value?

Closely related to risk tolerance is risk capacity: the client’s ability to weather financial storms as measured by how much time they have until retirement, how much wealth they have, and their income.

Together, these two syndromes evaluate how much risk a client is able to handle. While they often go hand-in-hand, they can diverge. A client may have sufficient resources to handle a market crash (high-risk capacity) yet psychologically be very distressed watching the value of their assets fall (low-risk tolerance). 

Finally, the advisor must understand the client’s goals. For example, Morgan may be in their mid-sixties, and nearing retirement; they're looking mainly for capital preservation for their portfolio. Whereas, Alex is 30 years old; their objectives are to buy a home, to fund their children’s college education in a decade, and to save for retirement.

Building a Portfolio

Once the advisor creates a client ‘risk profile’ and ascertains the client’s goals, then the asset selection process begins. Most advisors or advisory firms have a variety of predetermined "client portfolios," also known as "model portfolios." It would be inefficient to build from scratch a new portfolio for each individual client. These client portfolios are based upon the firm’s investment policy and strategy; they then are integrated with the particular needs of individual clients. , Inc. (MORN), Dimensional Fund Advisors, and many other research firms provide portfolio back-end assistance to financial advisors, especially if they're solo practitioners. Morningstar, for example, provides tools to help advisors from start to finish. Along with back-end help, they have ways for the advisor to construct, analyze, and monitor client portfolios. These tools are informed by asset class research. The individual advisors can even put their brand stamp on pre-selected Morningstar portfolios.

Then there are automated technology-enhanced financial advisors, sometimes referred to as "robo-advisors," which base their investment choices on strategic algorithms.

Larger financial advisor firms—especially those that are active money managers—often have a research team or department devoted to investment analysis and asset selection. These financial and research analysts also use a technique called alpha to help determine how much a portfolio's realized return differs from the return it should have achieved.

Model Portfolio Strategies

Some investment advisory firms support research which suggests that it’s very difficult to beat the market and therefore create index fund offerings in various flavors, depending upon the investor’s risk profile. Dimensional Fund Advisors, for example, offers a low-fee assortment of funds (sold only through professional advisors), based upon Nobel Prize-winning research of economists like Eugene Fama, Kenneth French, and Myron Scholes.

Monte Carlo simulations are sometimes used to assist advisors in selecting client investments. The Monte Carlo model creates a statistical probability distribution or risk assessment for a particular investment. The advisor then compares the results against the client’s risk tolerance to determine the efficacy of a particular investment. Running a Monte Carlo model creates a probability distribution or risk assessment for a given investment or event under review. By comparing results against risk tolerances, managers can decide whether to proceed with certain investments or projects.

The Bottom Line

How advisors choose investment portfolios is a varied process, and investors are wise to check with their particular financial advisor to find out how they make their investment choices. Additionally, it’s important to ask how your financial advisor is being compensated—because that may influence their selection of particular investments. Unless the advisor is paid as a percent of assets or with a flat fee, they could have an incentive to choose products, or a brand of products, that pay a higher commission. The emphasis is on the "could": Many commission-based financial planners subscribe to a fiduciary duty, and only recommend vehicles and strategies that fit the investor first and foremost. Still, both clients and advisors will be best served by discussing how assets are selected at the outset of their relationship.