In the end, it all comes down to the way your portfolio is designed.
Investors today are faced with a daunting task - how to sock away enough money so that they won't end up living in a van down by the river in their golden years. After your paycheck stops, and it will, what will you count on to at least keep the same standard of living that you are accustomed to? Pension? Sorry - they have been raided and mishandled for decades, and very few organizations offer them today.
Social Security? It's not a retirement account - it's a safety net. That means it's only there to keep you from having to eat cat food in your retirement years. And there are powerful forces in the government who want to cut benefits drastically.
The hard truth is that unless you were born into wealth, have mad athletic abilities, won the state lottery, or work for Goldman Sachs (NYSE:GS), you're going to have to fend for yourself. That means funding your own retirement any way you can. Smart money management can help you squeeze the most value out of every dollar you have saved for that rainy day. It's up to you, and nobody else.
Navigating the world of investing can be overwhelming
There are so many choices and so many products available in the marketplace that it can easily become overwhelming. It's time to stop and take a breath. Investing doesn't have to be hard. It can be simple, and I'll show you how.
For the next few minutes I want you to forget about the latest move in the Dow Jones, or the latest pronouncement by the Fed, or the scary headlines about North Korea, Russia, Iran, Syria, and the rest of it. For the next few minutes I want you to consider the simplicity, the elegance of a well-designed portfolio. It's not rocket science. It's common sense. And if you can find the will to do a little work up front, you will be rewarded with a bunch of extra time to enjoy the things that are much more important to you, like family, friendships, career, and dreams of a better future.
Designing your portfolio - from elegant simplicity to unnecessary complexity
In this article, I will attempt to bring some clarity and simplicity to the task of designing a portfolio that will fit you like a glove. Your portfolio doesn't have to be complicated unless you're into the whole complicated thing. It just has to be right for you. I will begin with a list of asset classes that are available for investors to choose, using ETFs or Mutual Funds.
There are 37 asset classes in my list. There are many more available to investors, but I decided to limit my list to the asset classes that will be familiar to most investors.
Next, I will describe the composition of the Global Market Portfolio. This will show the amount of money invested globally in each of the major asset classes. Put differently, this is where the world's money is invested.
I will then show how you can design a portfolio that is tailor-made for you. I will begin with an ultra-simple portfolio, and then to drill down in increasing levels of complexity from there. The simplest portfolio has just 2 assets - stocks and bonds. The most complex has 14 assets. How many holdings do you currently have in your portfolio? If it's more than 14, you may be trying too hard.
After all the reading, research, and advice you get from friends and experts, your investment results ultimately come down to one thing - your portfolio design. This is where the rubber meets the road, and all the theoretical mumbo-jumbo about things like Modern Portfolio Theory, active vs. passive investing, Sharpe ratios, Sortino ratios, volatility and hedging goes out the window.
But how does one go about designing a portfolio that reflects their needs, risk preferences, and investment objectives in the best possible way? The answer is closer than you might think.
Get these things right before going any further
There are a few key issues for you to consider and resolve before you go any further. First, don't fall for the Wall Street line that investing is too complex for you to do yourself. They say you need a professional to design your portfolio and to keep you from doing dumb stuff. Really? Does Wall Street really think you're that incompetent?
Here's the truth: Anyone who is willing to devote about 2 to 3 hours per year to the task of managing their investments is perfectly capable of achieving satisfactory results. As a bonus, by avoiding the fees and expenses that advisers and other intermediaries charge, you get to bank an extra 1% or so per year. What's the big deal about saving 1%? When you compound your returns over 20, 30, or more years, that 1% turns into 5%, 10%, 20% or more that will end up in your account rather than your advisers'.
Where do you want your portfolio to lie on the spectrum of simple to complex? You can have a well-designed portfolio that only holds 3 or 4 ETFs, or you could have one that holds 10 or 15 ETFs. It all depends on two things - how finely you want to slice and dice the asset classes in your portfolio, and how much time and effort you're willing to devote to tracking and maintaining your portfolio. It's a choice that only you can make, and it had better be the right one. If it isn't, you'll end up trying to do something that you are not suited for. And that will bring nothing but frustration and disappointment.
The Menu of Major Asset Classes Available for inclusion in your portfolio
|Total US Stock Market|
|US Large Cap Stocks|
|US Large Cap Value Stocks|
|US Large Cap Growth Stocks|
|US Mid Cap Stocks|
|US Mid Cap Value Stocks|
|US Mid Cap Growth Stocks|
|US Small Cap Stocks|
|US Small Cap Value Stocks|
|US Small Cap Growth Stocks|
|US Micro Cap Stocks|
|Global ex-US Stocks|
|Intl Developed ex-US Stocks|
|Intl ex-US Small Cap Stocks|
|Intl ex-US Value Stocks|
|Pacific Rim Stocks|
|Emerging Market Stocks|
|Short Term Treasury Bonds|
|Intermediate Term Treasury Bonds|
|10-year Treasury Bonds|
|Long Term Treasury Bonds|
|Total US Bond Market|
|TIPS - Inflation Protected Govt Bonds|
|Short-Term Investment Grade Bonds|
|Long-Term Corporate Bonds|
|High Yield Corporate Bonds|
|Other Precious Metals|
Does the above menu of choices make your head spin? Relax. You don't have to invest in most of these asset classes.
[The following tables and charts are based on the most recent Global Financial Stability Report from the IMF.]
Chart 1. The Simplified Global Market Portfolio
This is not the portfolio that I, or any rational professional would recommend, because the return history is sub-standard. The important point is that any portfolio that deviates from this baseline portfolio is, by definition, tilted towards one or more asset classes. Everybody tilts their portfolio, and it's not a bad idea to do so. But it's how you tilt your portfolio that matters.
This table shows just how simple the global market portfolio can be from a design perspective. All 37 asset classes can be herded into their proper categories and we will end up with just three broad categories - stocks, bonds, and cash.
Chart 2. The 4 Asset Global Market Portfolio
Next we take a baby step by adding real estate to the mix. Most of my clients are surprised to learn that real estate is only 5.7% of the global portfolio. They thought, as I once did, that real estate should be a much bigger slice of the global pie. The lesson here is that investing more than 5.7% of your money in real estate is a tilt away from the global mix of assets.
Chart 3. The 5 Asset Global Market Portfolio
Next we do the same thing with commodities. Since they are only 1.5% of the global portfolio, having a higher allocation to commodities is another example of portfolio tilt.
Chart 4. The Full Global Market Portfolio
There are 3 redeeming features of the full global portfolio design.
- It's so diversified that you would only need to check on it once per year.
- It has no asset class "tilt" which is an overweight or underweight position in certain asset classes.
- It covers about 90% of the total invest-able universe, giving you excellent diversification.
There are also a couple of drawbacks to this design.
- The historical returns for this portfolio design are mediocre at best. That's because it's too diversified. It's perfect in a textbook sense, but not very robust.
- For many investors, this design is boring. Some investors like boring because they have little interest in tinkering with their investments. This design is suitable for them, but for the rest of us it lacks imagination and it has limited upside potential.
Trying to be somebody that you're not
It's a very common mistake. You admire Warren Buffett or Jack Bogle or Ray Dalio, and you want to emulate their success. Well, that's a noble aspiration but it isn't realistic. Each of these giants of investing has resources, staff, and technology that you can't possibly compete with. They also have company contacts and deep relationships with other high-level players in the game.
I'm reminded of the time I decided to take up the game of golf at the ripe old age of 50 (I no longer play). The first three instructors I had tried to get me to do things with my swing that I was just not capable of doing. The 4th instructor told me to "play within your capabilities." That was great advice. He helped me evaluate the limits of my athletic capabilities, and then he designed a coaching program that focused on those abilities and nothing else. Designing a portfolio is very similar to this process.
Rather than trying to be like Buffett or Dalio or Justin Rose, it would be much more practical and effective to design a portfolio that fits your needs and objectives. If that sounds like I'm telling you to lower your expectations, it's because I am. But lowering your expectations doesn't mean settling for mediocrity. If you want mediocrity, just mimic the full global market portfolio and collect your 4-5% returns every year. That's not what I'm advocating.
Be comfortable in your own skin
Designing your portfolio effectively means being honest about who you are, how you make decisions, how much pain you can tolerate, and what you are actually trying to accomplish. If you're wealthy and don't need to depend on your investments, invest in short-term treasuries and take the 2-3% yield. You will probably stay one step ahead of inflation, and that's all you really need. Why take unnecessary risk?
If you're not wealthy, but you're aspiring to be wealthy, you need to take a little more risk. But stay within your capabilities because if you try to be a stock market gunslinger, the chances are very high that you will fail to meet your objectives.
It all comes down to how your portfolio is designed. And part of the design process is knowing how much year-to-year volatility you can take. Most investors over-estimate their ability to withstand drawdowns in the value of their portfolios. They design an elegant and efficient plan, and then along comes 2008 or 2001 and their plan goes out the window.
It would be much more effective to anticipate these severe market downturns and build them into your plan from the outset. With my clients I use a gradual risk reduction strategy when things begin to get dicey in the market. These strategies are specific, methodical, and put down in writing. This is something that every investor should do, because in the heat of the moment, all rationality fades away and emotions take over. This is not the way to manage your investments.
What to do with this information
Now that you know what the global market portfolio looks like, your challenge is to figure out how to tilt your portfolio in a way that makes sense for your investment objectives and risk preferences. But this assumes that you know what your objectives and preferences are. Therefore, the first thing you should do is spend some time on self-reflection. An honest assessment of who you are as an investor will be invaluable in this process.
The next step will be to design your portfolio. Not an easy task. But it's all about tilt - how far do you want to deviate from the global portfolio? How much pain are you willing to take when it comes to drawdowns? What rate of return do you really need? Do you just want to beat the S&P 500? That's not very helpful. In fact, I think it's a stupid goal to have. Your goal should be achieving the rate of return that you need to fund your financial needs. Investors who are obsessed with beating the market are suffering from myopic thinking. Expand your vision and think about what you actually need to earn.
There's an ETF for that
Thanks to the boom in ETFs over the last 20 years, there is now an ETF for every asset class in the global market portfolio. Most of them are low cost, and they track the movement of the underlying asset class. When it comes time to implement your elegantly designed portfolio, you will have many choices available.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.