This is the first in a series of 7 posts that will describe how to design and implement your own personal portfolio. Many beginning investors feel so helpless with this task that, in retrospect, always seems so easy, that they run to a financial advisor for assistance. Unfortunately, some writers suggest as many as 93% of financial advisors are simply salesmen, and so many of these naive investors don’t get started off on the right foot. Hopefully, after finishing this series, you’ll be prepared to design and implement a simple, yet sophisticated, portfolio yourself, or at least gain the skills and knowledge necessary to know when an advisor is “selling you down the river.”

**Set Specific Goals**

The first step in designing a portfolio is to set a goal for that portfolio. It might be to pay for your retirement, to pay for your child’s schooling, to buy your first house, to make a charitable donation at your death, or even to leave a certain amount of assets to your heirs when you pass. The more specific the goal, the better. You want to not only specify exactly how much money you need, but also, the exact date when you need it. An example of a good goal is “I want to have $100,000 in junior’s 529 plan on September 1, 2023.” Examples of a poorly-defined goal include “I want to be able to retire someday”, “I want to make as much money as possible with my investments,” or “I want to be a millionaire.”

**Plan For Change**

Naturally, life circumstances and goals change as the years go by. That’s okay. Goals, plans, and portfolios aren’t set in stone. If you let the fact that the plan will probably change later keep you from instituting it in the first place, you won’t reap the benefits of actually making a plan. Plus, if you never actually calculate how much you need to save toward a goal, you will almost certainly err on the side of saving too little, keeping you from ever reaching your goal.

**Plan for Inflation and the Sequence of Returns Issue**

If your goal is less than 5 years away, you’re probably okay ignoring inflation. Anything longer and you should use “real” or after-inflation numbers. That means if you calculate you need to save $20K a year to reach this goal, that’s $20K in today’s dollars, so you’ll probably have to contribute a little more each year. When you calculate the return you need, you will also need to use a lower, after-inflation return.

When saving for any goal, the sequence of returns matters. That means that ideally you get lower returns early on, when the amount of money saved is low, and higher returns later when the nest egg is large. Calculations like those I’m going to show you are by nature simplified, so recognize their limitations. Also, keep in mind that financial markets are not like physics. They are complex social institutions and there are precious few guarantees. There is a reasonable chance that the future will be very dissimilar from the past, so view past data with a very skeptical eye.

**How Much Do You Need Saved?**

You’ll have to make some kind of estimate for the amount you need to save. For a house you want to buy in 3 years, that may be relatively easy. You look at the price of similar houses, calculate the amount you’ll need for 20% down, maybe add a few percent more in case the value goes up (does that happen anymore?) or for closing costs, and there you go.

As the goal gets more complex, so does the estimate. For example, if your goal is to pay for tuition at your alma mater for your 3 year old, you’ll need to make some assumptions. Let’s say 4 years of tuition right now is $40,000 and you think tuition will go up at an amount 2% over the general rate of inflation. Pull out your favorite spreadsheet, such as excel, and put this into a cell:

=FV(2%,15,0,-40000)

=$53,834.73

The first number is the annual return. The second, the number of years. The third, the amount paid in each year, and the last the amount you have now. So this calculation will tell you what that $40,000 tuition bill will be in 15 years. So you need $54,000 in today’s money to reach that goal.

Estimating the amount for your retirement nest egg is even more complex. Many studies and even entire books have been written on the subject. But the basic process is that you estimate how much money you will need to spend each year in retirement, subtract the amount you expect from any guaranteed pensions or Social Security, and then apply a “safe withdrawal rate” such as 3 to 4.5% per year. For example, you estimate you’ll need $100K per year in today’s dollars, you have no pensions, and you expect Social Security to contribute $30K per year, indexed to inflation. Thus, you need your portfolio to contribute $70K per year, indexed to inflation. You decide, after looking at the studies, that you’re comfortable with a 3.5% withdrawal rate. $70,000/0.035= $2 Million. So your goal might be “I want $2 Million (in today’s dollars) in retirement savings by July 1st 2030.”

**Don’t Take Shortcuts**

This step seems very basic, but it is frequently skipped, leading to numerous problems down the line in the process of portfolio design. The process is simple, but it is critical that you take it in order. First you set goals, second you develop an asset allocation, third you implement the asset allocation, and last you maintain the plan. We’ll be evaluating each of these in turn. The next post in this series will discuss the relationship between how much you need to save and the portfolio return you need, and thus the risk you need to take.

This reminds me of the comercials with the guy saying what’s your number.

While i have done the above, i find there are just so many variables involved and so many uncertainties that im not so sure how accurate my numbers really will turn out to be.

I think the key is to redue your number every so many years. The closer you get to your goal, likely the more accurate the projection.

I look forward to the rest of the series.

I agree. There’s a lot of uncertainty. But doing the exercise and being a little off (and needing to correct in a few years) is far better than never doing it at all.

“so you’ll probably have to contribute a little more each year. When you calculate the return you need, you will also need to use a lower, after-inflation return.”

I believe you only have to do one of these. If you say you need $2M in today’s money, and you calculate based on inflation adjusted returns, you don’t need to increase your contribution every time because of inflation. Conversely, if you calculate how much you need to contribute based on an 8% earning (non-inflation adjusted) you would need to increase the contribution with respect to inflation. Please correct me if I’m wrong, as that would constitute a big paradigm shift. And thanks for the 8 tips or med students…I am hitting a few of those!

Unfortunately, you have to do both. You have to save nominal dollars, not inflation adjusted ones. But they only grow at the after-inflation return. But when you do your calculation, you’re right that you don’t have to inflation adjust the contribution since you’re doing all your calculations after-inflation.

I don’t know if that makes sense, but I can’t think of a better way to explain it right now.

So maybe I misspoke. Let’s say you want $2M in 20 yrs.

3500/mo compounded annually @8% would get you $2M in 20 years if there was no inflation.

But if you want $2M inflation adjusted for 2%/yr, you need an 11.4% return, or to contribute 5200 monthly at that 8%.

That’s all assuming fixed contributions. But if you increase your contributions in line with inflation, you can just use that 8% return rate and you will adjust for inflation automatically (more or less). So in the original equation, just contribute $3500/mo now (assuming an 8% market return), and every year increase that amount to what $3500 now means after inflation adjustment for that year.

My whole point is that I don’t think you need to increase your monthly or yearly contributions in line with inflation AND adjust returns to inflation. If the stock market is averaging 8% but inflation is 2%, you don’t need to calculate returns of 6% based on contributing more and more each year (to match inflation).

My calculations are from calculator.net’s interest calculator (pretty good math explanation) and the Wikipedia articles on “Real versus nominal value (economics)” and “Real interest rates.” Both articles appropriately sourced with correct math.

I think we’re just talking past each other. I don’t see anything wrong with what you’re saying. If adjusting for inflation as you go along is too tricky, just do it in nominal dollars with an assumed inflation rate. For example, assume inflation will be 3%. Assume market returns will be 8% nominal. Assume you want $2 Million in today’s dollars in 25 years.

$2 Million * 1.03^25= $4.19 Million

How much do you need to save each year at 8% to get $4.19 Million? About $57K a year. That’ll obviously be easier to save that much as the years go by due to inflation.

Realizing you can generally save more each year, I prefer to do the calculation in after-inflation dollars. $2 Million in today’s dollars, 5% per year. You have to save $42,000 this year, then $42,000 * 1.03 next year. In that 25th year, you’re saving $42,000 * 1.03^25 = $88K.

Yep. We were saying the same thing! That cleared it up for me. Now if I could save that much a year instead of going into debt that much each year. Can’t wait to get back into the real world. Thanks for your help and love the website.

Pick pick a part this retirement income strategy. It is based off different white papers I have read on retirement income. I will retire at age 56(wife 57). Lets say I will have 1.2M in my 401K. Most rules of thumb say I can draw down 2.5-4% annually without worrying about out living my money. So for this argument lets say I can safely withdrawal 3% or $36,000 annually ($3000/monthly).

If I were to take $400,00and buy a 10 year certain joint immediate annuity I would receive $5488/month or $65,800/yr for 10 years. If I took another $400,000 and bought a DIA with a 10 year deferral I would receive about 2600/month or $31,200/year for life. The other $400,000 I would leave invested in 401k and if earning 3% annually would be worth $592,000 after the end of the 10 years. using the 3% draw down I could take $1500/month for $17700/year for a total of $4100/month and $48000/year. These scenarios deliver a far greater income stream than the $36,000/year from 100% 401k. And because the 10 certain gives me far more income than I need or will get after the 10 years is over I can save the difference or buy a smaller annuity and leave the rest in the 401K.

The other part of the equation in social security. Taking the full $5488/month for 10 years gets me to age 66 when I can receive full SS benefits and add that $2700/month to the rest of the pie.

I am sure I am missing something or bad math but it looks like a preferred strategy compared to investing 100% of 401K.

I tokk all of my income annuity numbers from immediateannuities.com calculator

I wouldn’t buy an income annuity 3 years out of residency. Take a look again when you get closer to 60-70.

The reason annuities pay out more than a 4% SWR is because there is nothing left at death.

Edit- NM, I got you confused with someone else. Yes, annuities allow you to spend more and it is reasonable to consider them (particularly single premium immediate annuities) as you enter retirement.

do these guidelines still hold true for 2018 and beyond > will you update them ? looking forward to them

It’s a pretty evergreen post. What do you think should be considered for an update?