In a previous post, I acknowledged the sad fact that investing is not that interesting to everyone.
If you are one of those incomprehensible beings who would rather think about art or sports or fashion or celebrity or literature rather than the nitty-gritty of investment theory, I confided in you that that was okay. I gave you an out.
I recommended that you invest your money in Betterment because it is inexpensive and it checks all of the boxes that are important for long-term results. And I stand by that recommendation.
But let’s be honest, life is not that simple.
Take your employer based retirement plan. You don’t get to choose out of the universe of investment products which one is best for you. You get to choose from the selections that some committee at your work decided was best for you. And who knows, maybe “the decider” played golf with the investment house representative a week before deciding on the elections. Maybe his motives are not perfectly aligned with yours.
I’ve made a decision about your mutual fund options because I’m a decisive decider. You’re welcome.
And I can almost guarantee you that whatever portfolio you choose will not be automatically rebalanced for you as is the case with a betterment account. So at least once a year you’ll need to revisit your plan. And you will need to sell winners and buy losers. Or you’ll have to pay for some target date retirement fund with no control over how your fund is allocated or how it changes over time.
Which is to say that it’s probably a good idea to have some understanding about portfolio construction even if it’s not your “thing.”
So here are some simple questions and answers that should you help understand the important boxes to check when designing a portfolio.
1. How much risk is the right amount of risk?
This is a tough one. There cannot be any hard and fast rules here.
In general younger you are, the more secure your job is, and the more guaranteed retirement income you already have, (think: pension/social security) the more risk you can afford to take.
If you are in a boom and bust industry like construction, it’s probably better to shift more to the conservative side of the spectrum. That way when the economy takes a downturn and you’re at risk for unemployment, your portfolio will not take as much of a hit.
2. How is risk tolerance translated into portfolio construction?
In general the ratio of bonds to stocks tells you how risky your portfolio is. The more high-quality/low volatility bonds you have, the less risky. The more highly volatile/high expected return funds you have, the more risky.
The standard rule here is that your risk should be your age in bonds.
So if you’re 40 years old you should have 60% stocks and 40% bonds in your portfolio.
There’s a little wiggle room here though. If you feel you can handle more risk and you want to chase higher returns, it’s fair to pretend you’re up to 20 years younger than you actually are when determining your bond allocation. And the converse is also true (you can make yourself up to 20 years older if the thought of losing money keeps you up at night.)
3. What funds should be in your bond portfolio?
In general I am persuaded by the argument that your bond portfolio should be made up of the least risky, government guaranteed, classes of bonds available.
Why? Because when the stock market tanks there is a so-called “flight to quality.” Put another way, when people pull their money out of stocks they have to put it somewhere. and where do they put it? In the safest area possible.
Definitely short-term US government bonds, and treasury inflation protected securities. Probably short term investment grade corporate bonds. And possibly municipal bonds for tax reasons.
One could make a very credible argument that just investing your bonds in a total bond market fund is rational as well. After all the goal of indexing is to match the market.
4. What’s the most important factor to look at when selecting a fund?
5. What percentage of my stocks should be domestic and how much international?
Your stock fund allocation should probably be anywhere from 20 to 50% international.
If you really want to match the market, then about 50% of the worlds money is invested in international stocks. So 50% would seem to be a good amount.
But I tend to believe in a little bit less international, simply because international funds are more expensive than domestic ones.
Personally I like 40% international.
But remember I’m only a doctor.
6. Where should I look to reasearch good quality funds?
Books. Or my favorite page on the web.
7. What other factors should I consider when selecting asset classes?
This is where you’ll really have to read some books.
You’ll have to decide for yourself which factors are most attractive to you.
Do you like the idea of value investing? Are you attracted by the risk-taking flamboyance of small size stocks or emerging markets? Maybe you’re a believer in the most human of factors, momentum.
The important thing is that whatever belief hold you should have faith in it, so that when your portfolio is underperforming the market, you have the conviction to stay in your positions for the probable rebound.
8. Are there any other sectors of the economy to think about?
Certainly. One could make a good argument for holding about 10% of your stock allocation in real estate investment trusts, to better reflect the role that real estate plays in our actual economy.
There are persuasive arguments for putting some part of your portfolio in commodities as well, as they can increase the efficiency of the portfolio and thus the annualized returns.
9. Are you still awake?
If the answer is yes; congratulations!
Now why not go check some books out at the library and read some real advice from someone with actual financial credentials?
