By Dr. James M. Dahle, WCI Founder
Many beginning investors feel overwhelmed and don’t know where to start when trying to design and implement their investment portfolio. They 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.
DIY investing can be overwhelming, but you’ve got this. An important principle to remember when designing and implementing your investment portfolio is “Don't Take Shortcuts.” This may seem 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.
- Set goals,
- Develop an asset allocation,
- Implement the asset allocation,
- Maintain the plan.
Taking things one step at a time, you'll be prepared to design and implement a simple, yet sophisticated, investment portfolio yourself—or at least gain the skills and knowledge necessary to know when an advisor is “selling you down the river.”
Table of Contents
Step 1 – Set Goals
Step 2 – Develop an Asset Allocation
- Best Asset Classes for Your Investment Portfolio
- List of Asset Classes
- Investment Portfolio Asset Allocation
- Investing Portfolio Asset Allocation Examples
Step 3 – Implement the Asset Allocation
- Selecting Investments for Your Portfolio
- How to Get Started Creating Your Portfolio
- Choosing Investment Accounts for Your Portfolio
Step 4 – Maintain the Plan
The first step in designing an investment 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 die.
Set Specific Goals
The more specific the goal, the better. You'll want to specify exactly how much money you need and 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 Sept. 1, 2035.” 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 OK. Goals, plans, and portfolios aren't set in stone. If you let the idea 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 five years away, you're probably OK ignoring inflation. Anything longer and you should use “real” or after-inflation numbers. That means if you calculate that you need to save $20,000 a year to reach this goal, that's $20,000 in today's dollars (not in tomorrow'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 skeptical eye.
Determine How Much You'll Need to Save
You'll have to make some kind of estimate for the amount you need to save. For a house you want to buy in three years, that may be relatively easy. You look at the price of similar houses, calculate the amount you'll need for 20% down, and maybe add a few percent more in case the value goes up or for closing costs.
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 four 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:
The first number is the annual return. The second is the number of years. The third is the amount paid in each year, and the last is the amount you have now. 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.
The basic process is:
- 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.
- Apply a “safe withdrawal rate” such as 3 to 4.5% per year.
For example, you estimate you'll need $100,000 per year in today's dollars, you have no pensions, and you expect Social Security to contribute $30,000 per year, indexed to inflation. Thus, you need your portfolio to contribute $70,000 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 1, 2040.”
Now that you know the goals of your investing portfolio, we will examine the relationship between how much you need to save and the portfolio return you need—and thus the risk you need to take.
When Will You Reach Your Investing Goals?—Investment Returns vs. Savings Rate
We'll begin discussing the concept of asset allocation and further explore the future value function and the relationship between how much you need to save, your portfolio return, and time.
Open up your spreadsheet again and put this future value function into a cell.
This function says that if you start with nothing (0), save $60,500 a year for 20 years, earn 5% after-inflation each year, you'll have $2 million in today's dollars after 20 year. Now, $60,000 seems like an awful lot of money to save each year. I mean, you're only making $200,000, you've got a fat mortgage, two kids in private school, a high tax bill, and payments on the Porsche to make, right? What other options are there to get to that $2 million figure?
The four terms are all dependent on each other, but this concept is so important to your investing plan that we can't spend too much time on it. Let's say you can only save $30,000 a year. Let's assume you still don't have anything to start with and you still earn 5% real on your investments. How long is it going to take to get to that $2 million figure?
An extra 10 years. Hmmmm. Now you're deciding between that big house with the expensive mortgage vs. working 10 years longer. What other options do we have?
Well, you could get an inheritance, so let's say you have $300,000 in your retirement accounts already. How long do you have to work now if you save $30,000 a year and earn 5% real?
Now you get to $2 million in just 21 years and 9 months.
But what if you OWE $300,0000 in student loans (let's assume 0% interest, just to keep things simple) and really want to retire in just 25 more years? How much do you need to save/use to pay down loans each year?
It turns out $63,200 per year.
You can play around with this function yourself for a little bit just to get an idea of what is possible.
What About Investment Return?
That's pretty cool, you say. Don't you feel empowered now? Now you too can generate all those fancy charts and graphs financial advisors like to wow you with.
But there's one factor in that function that is much harder for you to control—your return. Wouldn't it be wonderful if you could just double your return?
For example, let's say you only want to save $30,000 a year, you have nothing now, and you still want to retire in 20 years? What kind of return do you need?
That's 11.3%. It seems a lot easier to just get that 11.3% return than to sell the Porsche or to live in a small house, doesn't it? Why not just do that?
Unpredictable Nature of Market Returns
The source of your return is the financial markets. Market returns are impossible to predict, much less control. This goes for the stock market, the bond market, the real estate market, the commodities market, or any other market you want to invest in. You can control the amount of risk you take, but that only has a moderate amount of correlation with your actual returns. It is important to understand the concept of expected returns.
Your expected return is what you expect to get for a given level of risk, on average, over many years. Even over many years, there are no guarantees, especially given the complex economic and political changes that occur frequently around the world and in your own city and country. But if you have no idea what to expect, you can't possibly estimate how much you need to save.
Historical Investment Returns
One source you can look to for estimating your returns is the past. As every investment prospectus is required by law to mention, past returns are no indication of future returns. But they do help define a range of possibilities.
Realistic Stock Market Returns
Let's take a look at the U.S. Stock Market for instance. If you invested in the low-cost Vanguard 500 Index fund since its inception in 1976, your average annualized nominal (before-inflation) return would be 9.51% from 1976-2020. Inflation from October 1976 until 2020 has averaged about 3.51%. So the real return of the U.S. Stock Market (including dividends and subtracting out very low investment costs) is 6.00%.
If the future is like the past and you invest in a 100% stock portfolio, you could use an expected return of 6.00% in your calculations. Note how different this number is from the 11.3% discussed above. That really demonstrates how unrealistic the plan is to only save $30,000 per year and to retire in 20 years on $2 million. Even if you got this 6.00%, you would fall $896,000 short of your goal.
Bond Market Returns
What about bonds? Vanguard started its “Total Bond Market Fund” in 1986. The average annualized return since then has been 5.93%. Inflation over that time period is 2.58%, leaving a real return of 3.35%. If we use that as an expected return, a portfolio of 50% stocks and 50% bonds would expect a return of 4.68%, not counting any rebalancing bonus (more on that later).
We do have more data on long-term stock and bond returns, with the best data set going back to the 1920s and some even going back a couple of hundred years. But those numbers aren't all that much different than what we've discussed above.
Theoretical Investment Returns
Another way to look at returns is from a theoretical perspective.
Theoretical Bond Returns
If a bond investor really expects 4% real returns going forward from this point, most authorities would tell him he's crazy. Part of the reason for the relatively good bond returns over the last 22 years is that interest rates have been falling, giving bond returns a nice tailwind. At the end of 1989, 10-year treasury bonds were yielding about 8%. Now they're yielding less than 2%. The best predictor of future bond returns is the current yield, and that's a nominal (before inflation) number. Pretty depressing, huh?
Theoretical Stock Returns
You can also estimate real stock returns theoretically. The most common way is the discount dividend model. You basically add the expected dividend yield to the expected GDP growth. There is a speculative factor as well, but over long time periods, that can generally be ignored. The yield of the S&P 500 when this post was originally written in 2020 is almost 2%. Economists are estimating around 3% for the long-term GDP growth. Add those together for a 5% real return.
Using these theoretical returns, we can calculate the long-term expected real return for a 50% stock, 50% bond portfolio at 2.5%.
Take More Risk for a Better Investment Return
There are ways to take on more risk in hopes of getting more return. You can invest in a stock-heavy portfolio and even include riskier stocks that theoretically have higher expected returns, such as microcaps, small value stocks, or emerging market stocks.
Real estate also promises some higher returns, especially when using significant leverage.
But the bottom line is that the expected after-inflation return number you should use in your portfolio return calculation is somewhere between 2-7%. If you (or your advisor) are making calculations using 10% or even 12%, your plan is probably doomed to failure.
You Need to Save More Money
Let's return again to the future value function. If you want $2 million in 25 years and have nothing now, you'll need to save somewhere between $65,500 (2% returns) and $31,700 (7% returns) per year. The riskier your portfolio and the more optimistic you are about the future economy, the less you can save. But putting away $20,000 a year just isn't going to cut it, and $50,000 might not even be enough.
Remember, step 1 in designing a portfolio is setting specific goals. As you begin to implement an asset allocation, remember the specific goals you want to reach with your investment portfolio. To reach those goals, it is important to realize the relationship between how much you need to save and how much of the “heavy lifting” your portfolio will provide through its compounded returns. See why I said, “If you don't know how much you need to save you won't save enough?” A comfortable retirement requires far more savings than most people think.
When designing a multi-asset class portfolio, one of the hardest steps is the second step—to decide which asset classes you should include.
An ideal asset class has three important characteristics:
- It has a long-term positive expected return, preferably much higher than the expected inflation rate.
- It has a low correlation, preferably even a negative correlation with all your other asset classes.
- It has enough securities within the class to minimize individual security risk.
If an “asset class” only contains 10 stocks, that's not a very good asset class.
How Many Asset Classes Do You Need in Your Investment Portfolio?
My opinion is that you need at least three asset classes in your portfolio. Seven is a pretty good compromise between the benefits of simplicity and the possible better performance of a complex portfolio. Once you have more than 10, you're just fooling yourself that you're doing any good and you're really just tinkering for the sake of tinkering. The law of diminishing returns really starts kicking in as you move past 3-7 asset classes.
I can think up a couple of dozen relatively common asset classes. It's easy to see you don't need to include ALL of them to get the benefits of a truly diversified portfolio. Also, some broad-based funds can give you access to several asset classes at once.
In fact, Mike Piper who blogs at The Oblivious Investor changed his entire portfolio to just a single multi-asset class mutual fund. Simple, yet sophisticated.
How Much Complexity Do You Desire in Your Investment Portfolio?
The more asset classes you add, the more complex your portfolio becomes. That does several things:
- A more complex portfolio might give you the opportunity for increased returns, especially if a lot of the asset classes are high-risk/high-return classes.
- It is guaranteed to increase your investment costs and the time required to manage the portfolio.
You might not mind complexity, but you also need to consider your spouse and/or heirs. It's not uncommon for heirs to discover that the portfolio of their recently deceased beloved contains 200 individual stocks and another 50 mutual funds. Guess what they're going to do when you die with a portfolio like that? They're going to run to the nearest Edward Jones store and hire those people to do it for them.
You also need to keep in mind that if your portfolio is split among five or more different types of accounts, then having 15 different asset classes is going to make keeping track of it immensely complex. But if all your investments are in one Roth IRA then perhaps that isn't such an issue.
Tax Considerations When Choosing Asset Classes
As William Bernstein related in his excellent discussion of Taxable Ted and Sheltered Sam, if your investments are primarily in a taxable account, you probably want fewer, more broad-based asset classes rather than many, narrow asset classes in the portfolio. This not only improves the tax-efficiency of the individual investments, but it also simplifies rebalancing down the road.
Unique Asset Class Opportunities
You may also have the opportunity to include asset classes that other people don't, and you should take these into consideration when designing your portfolio. This may be a function of what is in your 401(k), or it may be related to your individual business.
For example, when I was in the military, I had access to the government 401(k), the TSP. This very-low-cost plan contains a foreign developed market index fund (I Fund) offered at very low cost, as well as an extended market fund (S Fund) that is much cheaper than can be bought anywhere else, including Vanguard. It made sense to use these building blocks in designing my portfolio given how attractive the opportunity was. In addition, the TSP offers an asset class not offered anywhere else, the G fund. This is a money market fund on steroids, offering the yields of a 10-year treasury with the risk of a 3-month treasury bill.
Others may have access to the TIAA-CREF real estate fund, which functions quite differently from a REIT fund. You might also have the opportunity to buy syndicated shares of a surgery center, urgent care, or even your hospital. This unique asset class might only be available to you, and that should be considered when building your multi-asset class portfolio.
Mattress Money: This is money you keep in the house or in the safe deposit box. It is physical money you can pick up on your way out of town after a natural disaster. It might be a stack of $20 bills, rolls of quarters, or even gold coins. It might be denominated in U.S. dollars, Pounds, Euros, or even Yen. It's probably worthwhile to have some of this as part of your emergency fund, but the expected real return on this asset is precisely the opposite of the inflation rate.
Savings, Checking, and Money Market Accounts: This is money at the bank. Not as accessible as mattress money, but at least it earns a little bit of a return. That return is generally no more than inflation (especially after-tax) and currently [as of 2021] is way less than inflation. But it is safe and quite liquid and generally covered by FDIC insurance. Money Market funds are a mutual fund that strives to maintain a value of $1 per share (usually successfully). There is no FDIC insurance, but historically, it has been able to offer slightly higher yields than bank accounts. Currently, that isn't really true. The money is safe and quite liquid as asset classes go.
CDs: Rules vary by the bank, but you can usually get to this Certificate of Deposit (CD) money pretty easily, although you usually lose some interest if you withdraw it early. The money is FDIC insured, and it generally earns more than a typical savings rate, especially for longer terms.
Loans to Government
Fixed-Income Treasury Bills: Very safe, very cash-like short-term (less than a year) loans to the U.S. government. Historically, it has barely beaten inflation before taxes.
Treasury Bonds: Loans to the U.S. government for longer periods of time, up to 30 years. Principal value can swing significantly with interest rate changes, but it's still considered quite a safe investment. Returns generally best inflation by a small amount.
Foreign Government Bonds: Similar to treasuries, except you also run currency risk (if the dollar rises in comparison to the currency your bond is denominated in, you lose money). Obviously, some governments are more likely to default than others.
Inflation-Indexed Bonds: In the U.S., these include TIPS and I bonds. Basically, you are guaranteed a real return, and the bond covers any unexpected inflation. Foreign governments and even some corporations also issue these. Returns should theoretically be lower than comparable nominal bonds but haven't been for reasons that aren't completely clear.
Loans to Business and Individuals
Corporate Bonds: Loans to businesses. In addition to interest rate risk, you also run default risk. Since these are riskier than treasuries, the return is usually slightly higher. They can be split up into various subclasses by term and by default risk. Higher-risk corporate bonds are known as junk bonds.
Foreign Corporate Bonds: Similar to domestic corporate bonds, but with currency risk. Some mutual funds hedge against that risk to virtually eliminate it but at the cost of a lower expected return.
Peer-to-Peer Lending: Investing in consumer loans to individuals. Initial returns are promising, but the risk of default can be ridiculously high. Liquidity and time required to manage the investment are also concerns.
Mortgage-Backed Securities: These bonds are composed of loans to homeowners for their mortgages. There are other types of asset-backed securities, but these are the most common.
Slice and Dice Asset Classes: Morningstar developed a 9-box way to view the equity markets, dividing stocks by size (large, mid, and small) as well as on the value/growth continuum (value, blend, growth). This provides nine asset classes from large-cap growth to small-cap value. All nine of these asset classes have their pluses and minuses and can be reasonably included in a portfolio, although some experts have argued that small growth should be avoided due to a “lottery effect.”
Sector Asset Classes: The U.S. economy (and thus the stock market) is frequently divided into numerous sectors, including financials, technology, energy, healthcare, etc. There are at least 11 of these.
REITs: Although traded on the stock market, many investors feel REITs are fundamentally different enough from other stocks that they can be considered a different asset class and not just a sector. Many popular static portfolios (such as Yale and Coffeehouse) include a separate slice of REITs in them.
Precious Metals Equities: These are companies that mine gold, silver, platinum, etc. They're considered by some, such as William Bernstein, as a separate asset class. Precious metals are great assets for gold and silver IRA accounts for those interested in starting their retirement that way.
Microcaps: Many, such as Rick Ferri, consider microcaps a separate asset class. These are the smallest stocks that are publically traded on the stock market. Theoretical returns are promising. Actual returns can be disappointing as it turns out this is a hard class to invest in well.
Over-the-Counter Stocks: These are stocks of tiny companies that aren't big enough to be listed on a stock exchange and must be bought and sold on “pink sheets.” There are significant issues with investing in this asset class (especially transparency and a high prevalence of scams), and it should probably be avoided by most physician investors.
Returns of most of these asset classes are generally expected to significantly outpace inflation but with significant volatility and the risk of temporary and permanent loss.
International Equity: All of the asset classes listed above in domestic equity could be recreated in every country in the world, producing hundreds of “asset classes.” (Think Brazilian microcap healthcare stocks.) But in general, when people talk about international equity asset classes, they refer to these:
- Developed Markets: This generally encompasses stocks in Europe, Japan, Australia, New Zealand, and other countries with highly developed economies. As you would expect, it can be subdivided by market capitalization and on the value/growth continuum.
- Emerging Markets: This asset class is composed of stocks that are in economies that are still developing: Brazil, China, India, Russia, and dozens of other countries. The higher risks of investing in these economies give this asset class a higher expected return than domestic or developed stocks.
- Frontier Markets: Want more risk? Why not invest in the Middle East and Africa? There are such serious issues involved in investing in most of these countries that it makes Emerging Markets investments look relatively tame.
- International REITs: Vanguard has a relatively new fund that allows for this asset class.
International value stocks and international small stocks are commonly held asset classes also.
Precious Metals: This includes gold, silver, copper, platinum, etc. Many investors hold one or all of these in their portfolios. The expected long-term return is inflation, minus expenses, but with its low correlation to other asset classes (and purported value as apocalyptic money), it is held by many. It can be held as metal in your possession, metal in someone else's possession, and in a half-dozen other manners, all with their pluses and minuses. Gold, in particular, tends to have long periods with disappointing returns and short bursts of outstanding returns.
Energy: You can invest in oil, gas, natural gas, uranium, coal, and even alternative energy directly. You can buy futures contracts on them; buy the stocks of companies that produce, refine, or transport them; buy wells; or even go into partnerships (MLPs) to invest in them.
There are pluses and minuses to each of these, and some promising expected returns due to taking significant risk and enduring impressive volatility. Those people aren't living in North Dakota for the weather.
Agricultural Commodities: You can “invest” in anything from corn to wheat to “pork bellies” to cocoa. Some suggest funds of collateral commodities futures have a place in the portfolio. Expected returns are near inflation, so the case for adding these to a long-term portfolio is primarily based on low correlations with more traditional asset classes such as stocks and bonds. Of course, there are a lot of speculators in commodities.
Non-Precious Metals: Steel, aluminum, copper, etc. These have similar issues to agricultural commodities.
Currencies: You can speculate on changes in currencies using various instruments. The expected real return is negative after costs.
Cryptocurrencies: Cryptocurrencies like Bitcoin are primarily an instrument of speculation as they are not a widely used currency (much less a stable currency) nor any sort of a stable store of value. It's been very popular the last few years, but it's not something I would put your serious money into. More info here.
Alternative Investments: Larry Swedroe, in his excellent The Only Guide to Alternative Investments You'll Ever Need lists 20 different alternative asset classes. The book is well worth a read before delving into any of these. I won't go into that much detail in my list.
Financial Products: This includes life insurance, annuities, options, futures, structured investments, preferred stock (a combination of a corporate stock and a corporate bond), covered calls, convertible bonds, and other derivatives. Each of these options has potential but the products tend to be complex, and complexity almost always favors the issuer over the investor.
Private Equity: Many companies aren't owned publicly and traded on the stock market. That doesn't mean they're not good companies. It can be a difficult asset class to invest in, often requiring high minimums and “knowing somebody.” Several articles suggest returns aren't quite as good as many thought in the past. There is obviously less transparency than in the public markets.
Hedge Funds: Ahh, the rich man's investment. There are a dozen different types of hedge funds out there. Their recent popularity has seriously diluted the talent. The question is whether there was ever significant enough talent to make up for the ridiculously high fees. It's probably an area for most to avoid when it comes to designing a simple portfolio.
Collectibles: Yup, if you'd have bought the Mona Lisa a couple of hundred years ago, you'd be doing pretty well. Not exactly a mainstream investment product, this category includes everything from art to Beanie Babies to baseball cards. These are generally hobbies, not investments.
There are more asset classes than you can shake a stick at. You obviously don't need most of them. Let's discuss how to allocate between them to form an asset allocation.
The process of deciding your investment portfolio asset allocation is very personal, because there really is no single right answer. There probably isn't even a single right answer for you. There are literally hundreds of reasonable asset allocations that, combined with a reasonable savings rate, will allow you to reach your financial goals. Don't worry too much about getting this step perfectly right. Besides, portfolios that are only slightly different only perform slightly differently. Perfect can be the enemy of good here. Consider these five aspects as you build your portfolio.
What Should My Stock-to-Bond Ratio Be?
A portfolio is traditionally composed of risky stocks and relatively riskless bonds. The ratio between these two is the most important factor for determining both the risk and the return of your portfolio and is the first thing to decide when putting your asset allocation together.
John Bogle's rule is that your stock allocation percentage should be approximately 100% minus your age. So if you're 25, you should have 75% stocks. If you're 75, you should have 25% stocks. No rule of thumb should ever be hard and fast, and there are plenty of good reasons to not follow this rule. But if you're not sure where to start, this is a great place.
Some have argued for as much as a “120 minus your age” rule, but I'll be honest: when I start seeing people advocating this, it usually is after a long run-up in stocks and shortly before the beginning of a bear market. That would put a 50-year-old at 70% stocks, which is probably a little on the aggressive side. I have two pieces of advice for you when deciding on your stock-to-bond ratio.
First, Benjamin Graham suggested you should never have more than 75% of your portfolio in stocks or less than 25% of the portfolio in stocks. Warren Buffett claims that everything he knows about investing, he learned from Benjamin Graham. I suggest you listen to those two. Your portfolio is not the place to be an extremist.
What Is Your Investment Risk Tolerance?
When you are first developing your portfolio, I suggest you be more conservative than you think you should until you pass through the fire of a bear market the first time to see how you react. The worst possible outcome for a portfolio is for you to sell low during a bear market just before your retirement. I have two colleagues who did just this. Guess what? They're still working shifts.
The time to learn your true risk tolerance is not during the last bear market before your retirement. It's during the bear market you go through in your 20s or 30s. During the bear market of 2008-2009, the U.S. stock market declined more than 56%. Other asset classes, such as emerging market stocks and REITs, lost even more. The U.S. stock market declined approximately 90% during the Great Depression. You should expect to lose at least half of the money you have invested in stocks 2-3 times during your investing career.
That means at least a 25% loss on a 50/50 portfolio. If you've never watched several years' worth of savings evaporate before your eyes, you don't know what it feels like in your gut to go through that. DO NOT overestimate your risk tolerance. It is far better to underestimate it. You can always ramp up the risk after your first bear market managing your own portfolio if you find you can tolerate it. In my experience, it is far more common for people to take on more risk than they can handle, and most end up buying high and selling low.
How Much International Stock Exposure Belongs in Your Portfolio?
Another difficult question for a portfolio manager (that's you, if you're managing your own) is how much of the portfolio you should expose to the unique risks faced by international stocks, including currency risk. There are lots of good reasons to invest internationally, including significant diversification benefits and the possibility of outstanding returns in many countries.
I personally recommend you invest at least 20% of the money designated for stocks in your portfolio in stocks of countries outside your home country. In my opinion, the maximum you should invest in international stocks is the market weight, which is currently about 55% of your stocks. Any number between those is reasonable.
Total Market Approach vs. Tilting Portfolio
One very reasonable way to invest is to just buy all the stocks and all the bonds. For example, you could design a portfolio that is 1/3 Total Stock Market Index (U.S. Stocks), 1/3 Total Bond Market Index (U.S. Bonds), and 1/3 Total International Stock Index (Non-U.S. Stocks). This has many benefits, including ultimate diversification, very low costs, and simplicity.
However, there are also good arguments for “tilting” the stock portions of your portfolio to riskier assets. That means holding MORE than the market weights of riskier assets such as value stocks, small stocks, junk bonds, and emerging market stocks. The hope is that you'll have higher long-term returns to compensate you for taking the additional risk.
An example of a tilted portfolio would be 25% Total Stock Market, 10% Small Value, 25% Total International Stock, 10% Emerging Markets, 25% Total Bond Market, and 5% Junk Bonds.
How Much to Tilt Your Portfolio?
Once you've decided you WANT to tilt your portfolio to some riskier asset class, you're left with the decision of how much to tilt it. The more you tilt, the more theoretical return you will get, but you have to weigh that against the loss of diversification and the additional risk. The reason small stocks have a higher expected return is that the risk is higher that they may not get that expected return, even in the long run. It's a bit of a Catch-22.
I suggest moderation in all things. Although some authorities have advocated putting all of your stock allocation into risky asset classes such as small value stocks, I recommend you keep your tilts small enough that you still have a significant chunk of your portfolio invested in all the stocks in the world and all the investment-grade bonds in your currency.
Splitting Up Fixed Income
Some investors also like to “slice-up” their fixed income allocation. The smaller your stock-to-bond ratio, the more important this issue becomes. I suggest you keep some portion of your fixed income in investment-grade nominal bonds or their equivalents (CDs or perhaps the TSP G Fund) and some portion in bonds indexed to inflation, such as TIPS. The percentages I leave up to you. If your bond allocation is relatively small and you want to keep it simple, there's nothing wrong with putting your entire fixed allocation into a total bond market fund.
As I mentioned above, there are dozens, perhaps hundreds, of reasonable asset allocations. I've outlined a number of popular ones here. The most important thing really isn't the specific portfolio you choose. The important thing (once you choose a reasonable portfolio) is that you stick with it through thick and thin, modifying it rarely, only for very good reasons, and after giving it great thought over a period of months. But for the novice asset allocator, I will provide three examples of portfolios I consider reasonable, as well as five portfolios I do not consider reasonable.
Reasonable Portfolio #1 – Relatively aggressive, with a tilt to small and some alternative asset classes
- U.S. Stock Market 20%
- Small U.S. Stocks 10%
- International Stocks 20%
- Small International stocks 10%
- Gold 5%
- REITs 5%
- TIPS 15%
- Total U.S. Bond Market 15%
- U.S. Stock Market 30%
- International Stocks 10%
- TIPS 10%
- Total Bond Market 40%
- Cash 10%
Reasonable Portfolio #3 – The portfolio of an asset-class junkie
- U.S. Stock Market 20%
- Small Value Stocks 10%
- International Stocks 10%
- Small International Stocks 5%
- International Value Stocks 5%
- Precious Metals Stock Fund 5%
- REIT Fund 5%
- TIPS 15%
- Total Bond Market 15%
- Junk Bonds 5%
- Cash 5%
Unreasonable Portfolio #1 – Extreme, lacks diversification and/or lacks growth potential
- Gold 60%
- Cash 20%
- Guns and Ammo 20%
Unreasonable Portfolio #2 – Lacks diversification due to no low-risk asset classes
- Total Stock Market Index 100%
Unreasonable Portfolio #3 – Too much international tilt
- Total International 50%
- U.S. Stocks 25%
- Bonds 25%
Unreasonable Portfolio #4 – Bizarre, huge tracking error, lacks diversification
- REITs 25%
- Gold 20%
- Silver 20%
- Transportation Stocks 15%
- China Stocks 10%
- Israeli Stocks 5%
- Mid-Cap Growth Stocks 5%
Unreasonable Portfolio #5 – Too complicated and slices are too small
- U.S. Large Growth Stocks 3%
- U.S. Mid-cap Growth Stocks 1%
- U.S. Small-cap Growth Stocks 3%
- U.S. Large Blend Stocks 3%
- U.S. Mid-cap Blend Stocks 3%
- U.S. Small Blend Stocks 3%
- U.S. Large Value Stocks 2%
- U.S. Mid-cap Value Stocks 3%
- U.S. Small-cap Value Stocks 2%
- Microcaps 3%
- REITs 3%
- International REITS 3%
- Large International Stocks 3%
- International Growth Stocks 4%
- Emerging Market Value Stocks 5%
- China Fund 3%
- Small International Stocks 3%
- Gold 2.5%
- Silver 2.5%
- Copper 1%
- Platinum 1%
- Employer's Stock 5%
- TIPS 4%
- Short-term Treasuries 6%
- Short-term Corporates 7%
- Long-term Treasuries 8%
- Junk Bonds 3%
- Peer to Peer Lending 2%
- Energy Stocks 4%
- Commodities Fund 4%
It's now time to implement the asset allocation. This involves selecting the actual investments to fulfill the asset allocation, deciding what types of accounts to use, and determining where you should locate each investment within those accounts.
You've basically got three choices when you select investments:
- Select individual securities yourself.
- Pay someone else to select investments for you through traditional mutual funds or ETFs and have them manage the investment actively (trying to beat the market).
- Pay someone else to manage the investment passively.
Passive vs. Active Investment Management
I favor passively managed mutual funds for three main reasons:
#1 Active Management Is Really Hard
If this is news to you, I suggest a quick read of Rick Ferri's The Power of Passive Investing. He puts together academic studies done over decades that demonstrate that while beating the market is possible, it is highly unlikely and becomes more unlikely the longer the investing time period and the more investments that need to be selected.
#2 Active Management Is Really Expensive
In fact, that's a big part of the reason why passive funds outperform active funds. (The other big reason is primarily behavioral.) Years ago, the only funds available were actively managed. That provided a benefit to investors since they could get wide diversification at a much cheaper price than they could get themselves. There was little focus on “beating the market” since you couldn't buy the market.
When index funds showed up, other mutual funds had to focus on beating the market, and it turned out it was much harder to do than anyone imagined. The expense ratio on funds easily available to any investor is less than 0.1% per year or less than $1 per $1,000 invested.
#3 Passive Management Is Really Easy
You select a fund based on only three factors:
- Which index does the fund follow
- How well does it follow the chosen index
You don't have to learn all about the manager's background, evaluate their track record, and constantly monitor their activity so you can get out quickly if they ever “lose their touch.” You just buy it and forget it. Passive investors get mad when their fund doesn't have a return within a few basis points of the benchmark index, which is a pretty rare event for most popular index funds.
Traditional Index Mutual Funds vs. ETFs
Some people spend a lot of time worrying whether to use traditional index mutual funds or ETFs. The truth of the matter is that it doesn't matter all that much. Expenses are similar, and true advantages of one over the other for most investors are minimal. Mutual funds are generally easier to use since you don't have to interact with the market, but in some of the more obscure asset classes, an ETF is markedly better than a fund.
The process for most of us goes like this: if I want, say, 5% of my portfolio in REITs, I look for a passively managed REIT fund and put 5% of my portfolio in it. I want 5% of my portfolio in emerging markets, so I look for the best passively managed emerging markets fund and put 5% of my money in it. It's pretty simple.
If you're not sure where to start looking for passively managed funds, go to Vanguard. You don't necessarily have to have all your investments at Vanguard, but you probably ought to have a pretty good reason to invest somewhere else.
The hard part is the asset allocation, not the selection of the investments. But too many people don't do these steps in order, and that's where things seem confusing and complicated.
This step can make a big difference. I'm often surprised to see people not using the appropriate type of accounts for their situation. For example, a resident who isn't investing for retirement in a Roth IRA. Or parents saving for their children's college in a taxable account instead of their state's 529 plan. Or a doctor at the peak of her earnings career choosing a Roth 401(k) or even a taxable account instead of maxing out his tax-deferred 401(k) contributions. Everyone's situation and outlook are a little different, but using the right accounts for the right reason can make a huge difference in your after-tax returns over the years.
If all of your investment accounts are tax-protected, this step doesn't matter so much. If you have a significant taxable investment account, however, you need to pay attention to this step. As a general rule, you should use tax-protected accounts as much as possible, and when you have to invest in a taxable account, you should place your tax-efficient assets there first. So if only 50% of your investments are within tax-protected accounts, and your desired asset allocation is:
- 20% Total U.S. Stock Market
- 20% Total International Stock Market
- 20% Small Value Stocks
- 5% REITs
- 15% TIPS
- 20% Total Bond Market
Then you'd want to rank the assets in order of tax-efficiency. Here's that list in order from most efficient to least efficient:
- Total International Stock Market
- Total U.S. Stock Market
- Small Value Stocks
- Total Bond Market
You would then place your assets like this:
Tax-protected accounts 50%
- 15% TIPS
- 20% Total Bond Market
- 5% REITs
- 10% Small Value Stocks
Taxable account 50%
- 10% Small Value Stocks
- 20% Total Stock Market
- 20% Total International Stock Market
There are a few subtleties to this process, but in general, it's pretty straightforward. If you're not quite sure you're doing it right, consider posting your desired asset allocation and how you're planning on implementing it on the WCI forum or Facebook Group. You'll have valuable feedback within minutes and some reassurance that you're doing it right.
The final step in designing a solid, low-cost, do-it-yourself portfolio is managing your portfolio. As we've discussed, the easiest (and undoubtedly one of the smartest) portfolios you can have is a fixed-asset allocation of low-cost index funds. There are a few tasks that remain.
Tracking Your Investment Returns
An important part of planning for the future and maintaining your asset allocation is to track your returns. This need not be done on a daily basis, but should at least be looked at once a year and tracked over the long term. I suggest you use the XIRR function to do so. As the years go by, this data becomes more and more valuable. If, for example, your plan for financial independence is to have $2 million in 25 years and you determined upfront that you need to save $42,000 a year and average 5% real returns (after taxes and expenses) to reach that goal, you ought to calculate your returns as you go along to see how you're doing. If after seven or eight years you see that you're actually only getting 4% real returns, then you can adjust by saving more money or perhaps even taking a little more risk than you thought you had to in the portfolio. Perhaps your plan was to get 10% real returns, and you realize how unlikely that seems to be after a few years of investing. You can now adjust the plan to spend less in retirement, work longer, or save more now. Investing without calculating your overall returns is like going on a road trip and never looking at a map, a GPS, or the road signs. You may run out of gas before you get there.
Rebalancing Your Portfolio Asset Allocation
A static asset allocation is going to be knocked out of balance by varying market returns. If you want to maintain the same level of risk in your portfolio, you'll need to rebalance back to the original asset allocation from time to time. For the beginning investor, with a small portfolio compared to his annual contributions, this is easily done by directing the new contributions to the asset classes that haven't done particularly well recently. As the portfolio grows, it may occasionally become necessary to actually sell something that has done well to buy something that hasn't.
Studies show you shouldn't rebalance more often than every year or two, so some people just do it on their birthday every year. Others rebalance when the portfolio becomes out of whack by a certain amount, by using the 5/25 rule (or similar). You should try to avoid any tax consequences when rebalancing, as the benefit of rebalancing could easily be eliminated by the tax costs. This means doing your rebalancing predominantly within tax-protected accounts. You can also use distributions (dividends and capital gains) to new contributions to rebalance, further decreasing the need to sell appreciated securities within a taxable account.
When to Change Your Portfolio's Asset Allocation
You occasionally may come up with a good reason to change your asset allocation. This should occur rarely, and when I say that, I'm not talking every week or two. I'm talking once a decade or so. Remember, this is a strategic asset allocation we're talking about, not a tactical one. You don't change it in response to security valuations or recent market events. You need to be very careful about performance chasing, which is a very natural tendency that most investors fall into. I suggest you give yourself a waiting period, perhaps even 3-6 months after deciding to change the asset allocation before doing so. You may be surprised to see that after a three-month wait, you no longer think that change was such a good idea. Here are a few reasons why you might want to change your asset allocation:
Decrease in Risk – In general, as you get older, closer to retirement, and closer to your financial goals, you probably want to dial down the risk a bit, with safer assets like bonds and less risky assets like stocks. You may want to decide now how you plan to do this. Decreasing stocks by 1% a year or 10% a decade or whatever. You may also find you simply don't need to take as much risk after a raise, particularly strong market performance, or an inheritance.
Change in Life Circumstances – Perhaps you get married and your spouse doesn't like you investing in microcaps or you find you need a higher return than you originally anticipated. You may also gain access to different asset classes through a new 401(k).
Add an Asset Class – Every now and then, a new asset class comes along. If, after evaluating it, you find you want to add it to your portfolio, it's OK to do so. I do recommend you be very careful about performance chasing, however. It's easy to do, even for the “right reasons.”
Buy into a New Theory – You may come across some new investing research or theories that indicate a change in investing strategy. Examples from the past include the development of mutual funds, the development of index funds, the development of REITs, 3-Factor analysis into the benefits of small and value stock investing, or even momentum investing.
Stay the Course
Last, and perhaps most importantly, once you develop your portfolio, you need to stay the course. This is much easier said than done.
Not only do you have to ward off the constant urge to tinker, but you need to avoid reacting to market ups and downs. It helps if you don't pay any attention to the financial news. Investment consistency is far more important than the particular asset allocation you choose (as long as it is something reasonable). Changing horses in mid-stream is a recipe for getting wet.
You can do this, and we can help. In fact, we're more than happy to help you. To explore thousands of more posts from WCI over the past decade, you can start here. WCI also has plenty of relationships with a number of high-quality, pre-vetted partners that can assist you with financial planning, retirement accounts, tax planning, and real estate investing.
Does this plan for building and managing a portfolio make sense to you? Or did you go about it a different way? Did you have success? Do you wish you could have taken this path instead? Comment below!
[This updated post was originally published as a series in 2012.]