Basic financial principles to consider when building a portfolio include the following:
- Diversity across global markets
- Orientation toward equity or growth
- Inflation protection
- Low correlated assets
Diversity across global markets will include both developed international markets and emerging markets. To provide the necessary growth for retirement, the portfolio will need exposure to equity assets. A portfolio filled with bond ETFs will not suffice. Inflation protection will require holding U.S. Treasury Inflation-Protected Securities.
A second line of defense is to hold real estate-- both domestic and international, as a guard against inflation. Domestic equity holdings will also provide some protection against inflation. The last guideline, finding low correlated assets, is one of the most difficult to accomplish successfully. We frequently look to commodities for a solution to this problem.
Slicing the diversification problem further, one needs to decide how many asset classes to use when building a portfolio. The answer to this question depends on how one defines an asset class. For example, U.S. Equities can be considered to be one asset class or it can be divided into as many as nine asset classes. Definitions such as this are up to each investor. I favor breaking U.S. Equities into multiple asset classes in order to tilt the portfolio toward value, growth, large-cap or small-cap.
It is important not to slice the asset classes so thin that the percentage in a particular asset class is not able to contribute to portfolio movement. Asset classes such as bonds, domestic real estate, commodities, etc., should hold at least 5% of the total portfolio. One might go as low as 2% or 3% for one of the "Big Nine" asset classes within U.S. Equities.
Depending on the risk an investor is willing to take, a 70% allocation to equity orientated investments is reasonable. The remaining 30% is allocated to bonds or high yield generators. A very common stock/bond ratio is 60/40. Even a 60/40 portfolio, while conservative at first glance, carries a 90% risk associated with the 60% allocated to equities.
The general guidelines listed above are put into action when specific stocks, ETFs, or mutual funds are selected to build the portfolio. Numerous examples are described throughout my blog.