How To Build A Retirement Portfolio

| About: SPDR S&P (SPY)
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Summary

Investors who try to build their own retirement portfolio should follow a strict set of rules.

In this article, I analyze the process, which is in contract to the advice of most professional advisors and SA authors.

On the other hand, my strategy is in compliance with the advice of Warren Buffett.

Many SA members try to build their own portfolio in order to reach their retirement goals. To achieve these goals, they should follow a strict set of rules. Otherwise, they run the risk of switching strategies depending on the hot sector of every period, which is definitely a disastrous long-term strategy. In addition, by following a solid set of rules, they minimize the negative impact of their emotions on their performance. In this article, I will detail how investors can build a retirement portfolio with very high odds of success and minimum time spent.

Saving

First of all, they should start saving as early as possible and as much as possible. As Einstein said, compounding is the 8th wonder of this world. Investors should not underestimate the importance of providing as much time as possible to their savings to compound over time. In this way, they will achieve their ultimate goal even if their savings are compounded at a lower rate than expected.

On the other hand, they should not make painful sacrifices and huge compromises in their living standard. While they should cut their redundant expenses in order to increase their savings and let compounding do its miracle, they should also keep in mind that the present is at least equally important to the future. In fact, as the future is unknown and no one can predict how long he/she will live, the present is even more important than the future. Therefore, as long as one earns a decent salary, one should allocate a decent portion of it in the retirement portfolio while also maximizing the pleasure from life.

Commissions and fees

As long as investors save a decent portion of their salary, they should first find a discount broker with the lowest possible commissions and fees. While some investors underestimate the importance of commissions and fees, the reality is that they greatly affect the long-term performance of a portfolio. Therefore, investors should pick the best discount broker in order to gain an edge from the very beginning. I have discussed the impact of commissions on my portfolio in a previous article.

S&P vs. stock picking

Then they should identify the correct security to invest their savings. A surprisingly high number of advisors and SA authors recommends building a dividend-growth portfolio with 50-100 stocks that have a great record of raising their dividend. The extremely high number of stocks recommended serves to provide great diversification so that the income stream is hardly affected when one stock cuts or eliminates its dividend.

However, this number of stocks is totally unnecessary and carries a lot of drawbacks. First of all, the additional diversification from adding new stocks after the first 5-8 stocks is minimal. This is not just my view; it is also the view of the legendary investor Peter Lynch. Moreover, as the total amount is distributed across so many holdings, there is a huge cost of commissions and fees during the purchase and sale of these stocks and during the reinvestment of dividends. Most dividend-growth investors [DGI] will claim that they will never sell their holdings but the truth is that they will sometimes have to sell some stocks, most often during rough periods for the market. Therefore, they need to consider the cost of their transactions. Even if they sell very few of their stocks, the cost of buying shares and reinvesting the dividends is still appreciable.

Moreover, a portfolio with so many stocks will inevitably have the same return as that of S&P. It is simply impossible to pick 50-100 stocks from S&P and expect to significantly outperform the index. If a portfolio with so many stocks has a different performance from S&P, this simply means that most of the stocks belong to a specific sector of S&P and will thus inevitably track the performance of that sector. Therefore, I strongly advise investors to invest their savings on S&P, which is characterized by great advantages.

First of all, it offers even greater diversification than a 100-stock portfolio. In addition, unlike many stocks, S&P has always emerged stronger from every single crisis and has grown its earnings per share at a compounded 8.6% rate since 1960. This is a remarkable performance, which should not be underestimated. That's why a study found that the vast majority (86%) of active funds markedly underperformed the index. Moreover, investors will save a great amount of money in commissions and fees, compared to the 50-100 stock portfolio. They only have to select a low-fee ETF, such as SPDR S&P 500 (NYSEARCA:SPY), Vanguard 500 (NYSEARCA:VOO) and iShares Core S&P 500 (NYSEARCA:IVV).

While the savings from commissions make a big difference, the greatest advantage of S&P is that investors will not have to spend thousands of precious hours on monitoring every single stock of their portfolio. Investors who hold a great number of stocks are condemned to spend numerous hours on reading the news, the earnings reports and the presentations of their companies. Even worse, they should study all the available material and determine the prospects of their stocks on a regular basis. On the other hand, if they invest in S&P, they do not have to spend more than an hour per day on the markets.

Of course, most DGI investors will claim that they do not care about price fluctuations; they just enjoy receiving an increasing income stream. However, when a stock plunges for a while, it usually indicates that the dividend may be at risk. Therefore, an exhaustive due diligence is required in order to determine whether the dividend is really at risk. Moreover, most DGI investors have been spoiled by the ongoing almost eight-year bull market, which has minimized the frequency of dividend cuts. However, when the next recession occurs, a significant number of dividend cuts will occur, just like in every recession. If DGI investors do not monitor their holdings, they run the risk of incurring some capital losses that will erase years of dividends. The shareholders of Kinder Morgan (NYSE:KMI) should have learnt this lesson well, as the 50% plunge of the stock made its previously appreciated dividends look like a drop in the ocean.

Some investors also claim that they do not need to monitor their holdings, as they are great stocks with excellent records. However, this is a particularly dangerous delusion. More specifically, competition has heated so much in almost every single sector that investors cannot skip monitoring any of their stocks. To be sure, unique stalwarts, such as Wal-Mart (NYSE:WMT), Coca-Cola (NYSE:KO) and Procter & Gamble (NYSE:PG), which used to grow every single year for decades, have failed to grow in the last three years. Even worse, they do not have a clear growth path looking forward and they have just kept growing their dividends by raising their payout ratios.

Moreover, technological progress is so fast that it can hurt some previously excellent companies long before an investor can take notice. To be sure, no one imagined that the shale oil technology would cause the oil price to collapse and would lead so many oil companies, such as ConocoPhillips (NYSE:COP) and National Oilwell Varco (NYSE:NOV), to decimate their dividends. In another example, Fossil (NASDAQ:FOSL), which had an excellent record of earnings growth, has been severely hit by the iWatch of Apple (NASDAQ:AAPL). All in all, it is a very dangerous delusion to think that you do not need to monitor your holding nowadays. Therefore, S&P has a huge advantage over a portfolio with many stocks.

Unsurprisingly, this is actually the advice that the best stock picker ever, Warren Buffett, has offered to investors. He has repeatedly advised investors to stay away from picking individual stocks and instead invest their savings on a low-fee index ETF. When the best stock picker gives this piece of advice to the public, individual investors should probably listen.

Corporate bonds

While S&P has a great historical performance record, investors should note that it has recently posted a new all-time high. This is not a negative sign but it is also worth noting that it is currently trading at a markedly high P/E ratio, around 20. Therefore, it is reasonable to assume that its future returns from its current level may be somewhat lower than its average historical returns (8.6%). Consequently, investors may also want to consider purchasing some corporate bonds, which offer attractive annual returns, in the range 5-7%. For instance, my portfolio includes the 6.125% bonds of Credit Acceptance (NASDAQ:CACC), the 6.875% of Yum Brands (NYSE:YUM) and the 6.875% bonds of Ensco (NYSE:ESV). I strongly encourage investors to consider these bonds, as I believe they offer a great risk/reward profile under the current circumstances. I have detailed my thesis on each of these bonds in previous articles.

Dividend reinvestment

In any case, S&P ETFs are great investment vehicles for investors who try to build their own retirement portfolios. Investors should also keep in mind that they should reinvest the dividends they receive every year regardless of the prevailing conditions. For instance, if S&P is in a downtrend due to gloomy expectations for the economy, investors should not change their strategy and stop reinvesting their dividends. If they did, it would mean that their emotions interfered with the investment process, which is never a sound strategy to employ. Therefore, dividends should be reinvested on S&P with a steady process.

The steps

To sum up, investors should follow these steps in order to build their retirement portfolios:

1. Start saving early and as much as possible but without sacrificing their present.

2. Identify the discount broker with the lowest commissions.

3. Invest their savings on a low-fee S&P ETF and possibly on some corporate bonds.

4. Reinvest their dividends with a standard procedure.

5. Stick to their strategy even through rough times.

Strengths and weaknesses

As mentioned above, the above strategy has several strengths. First of all, it provides excellent diversification, as the investor essentially invests in the best 500 stocks of corporate America. S&P carries much less risk than any individual stock, which can plunge whenever its business model is disrupted. In addition, S&P has historically offered excellent returns, it has outperformed the vast majority of active funds and is likely to continue to do so for the foreseeable future.

Moreover, a portfolio invested in S&P is characterized by much lower commissions and fees than a portfolio of dozens of stocks. Furthermore, the former portfolio will save investors from spending numerous precious hours on monitoring their stocks, which involves following their news, reports, presentations and actions. This advantage will also help investors maintain a clear mind and thus make sound investment decisions.

The only weakness of the strategy is that it cannot make anyone rich overnight, as the returns of S&P are quite predictable over the long term. However, even those who try to pick their own stocks are more likely to receive poor returns than become rich in a short period. Only a very tiny minority of investors are great stock pickers, particularly nowadays that the market has become much smarter and much more efficient than it used to be.

Conclusion

To conclude, the simpler the strategy the more likely it is to succeed. It is a shame to devote thousands of precious hours to monitor dozens of stocks only to achieve a similar or inferior result. Instead, it is much better to follow a simple plan, which has always offered excellent long-term results, and stick to it. All in all, I believe that the above strategy is the one with excellent returns and the least amount of time spent.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long CACC, YUM, ESV bonds.