By Ronald Delegge
The difference between well-built and poorly designed buildings can be strikingly drastic.
Take for example, I.M. Pei, the Chinese-American architect, who is a legend in his profession and has won many prestigious awards, including the Pritzker Prize. Among all the illustrious structures he's designed, the Rock and Roll Hall of Fame in Cleveland, OH is the one edifice that he'd rather forget. Although the Rock and Roll Hall of Fame uses pyramid shapes that give it a recognizable look, the museum appears to be disheveled, disconnected, and lacking in continuity. Even Pei himself admitted the building he designed for rock "n" roll memorabilia has too many conflicting shapes that lack harmony.
Similarly, the portfolios that investors build for themselves or with the help of advisors can have major design flaws. One way to avoid flaws is to build portfolios with the right ingredients or building blocks. Let's examine five of these building blocks that are the basis of all architecturally sound portfolios.
Stocks, also known as "equities," are shares in publicly traded companies. And these shares come in many different sizes, shapes, and flavors. Generally, stocks are either large, mid, or small companies and they are either domestic or international.
The first priority of the prudent investor isn't to handpick a small group of the best stocks or even the best portfolio manager who proposes to pick the best stocks. Rather, the objective should be to obtain broad and diversified exposure to all stocks in a low cost and tax-friendly way. The easiest way to accomplish this all important mission is to use low-cost index ETFs.
After the objective of broad exposure to both domestic and international stocks has been achieved, the investor may decide to allocate risk capital or play money to individual stocks within the context of their non-core portfolio. (For more on the non-core portfolio, see )
Bonds are debt issued by companies, cities, or national or local governments. The value of bonds is impacted by variety of factors including the creditworthiness of the borrower, the bond's credit rating, and the interest rate cycle. When interest rates are rising, for instance, the increase in bond yields is offset by a decrease in bond values.
Although the longer-term performance of bonds has been less compared to stocks, fixed income as it's known, still has a valuable role inside your portfolio. How?
Bonds can provide diversification, stability, and uncorrelated returns during times when the rest of your portfolio might not be doing so well. For example, during the 2008 credit crisis, when many equity portfolios lost 40% or more in value, long-term U.S. Treasuries jumped almost 34% in value.
Real estate is another key building block for investors. Unlike stocks and bonds, real estate is a tangible asset, that can be seen, visited, and touched.
Compared to other portfolio building blocks, real estate is highly desirable because it produces income and it's a great inflation hedge. On the other hand, real estate is not quickly converted to cash, which means it can have lower liquidity compared to other types of assets.
An easy way to obtain domestic and international exposure to real estate is via index ETFs, which typically hold a broad lineup of real estate focused companies with professional management teams.
Although commodities have been out of favor for a long-time, this doesn't diminish their role as a core portfolio building block.
Commodities refer to physical assets like coffee, natural gas, oil, precious and industrial metals, along with livestock. These are crucial things that society uses and needs in daily life.
Prices for commodities are generally impacted by weather, politics, along with supply and demand. Because commodities do not have any earnings or dividends, they lack yield income, which can be a major disadvantage compared to other assets like stocks, bonds, and real estate.
During bull markets when stock prices are rising, cash is often referred to as "trash." That's because it can be a drag on portfolio returns. On the other hand, when market prices tumble, cash is valuable tool that many investors wish they had more of.
Aside from providing you with a portfolio cushion during turbulent markets, cash gives your portfolio lots of flexibility and liquidity. In contrast, investment portfolios that are invested to the hilt are unable to take advantage of falling prices because they are fully invested and therefore lack cash.
A tiny minority of investors have hit the jackpot by skirting the laws of gravity and concentrating all of their investments in just a few things. Although they may have succeeded up until now, they face the constant risk of imminent collapse. For the rest of us, a multi-asset class portfolio with complementary building blocks isn't just the right approach, it's the prudent one.
Disclosure: No positions
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