The following factors will influence an investor’s portfolio design and asset-allocation decisions:
- Target rate of return to meet financial goals.
- Risk tolerance.
- Investment time horizon.
- Investor psychology.
- The Investor’s Four Types of Capital.
- Degree of portfolio diversification and complexity.
Target Rate of Return
Ideally, each investor should prepare an investment policy statement that lays out his/her financial objectives. While this is beyond the scope of this website, you can learn more here and check out the resources page.
There are numerous free calculators available on the web that will help you determine the combination of regular savings, rate of return and time horizon to reach a retirement nest egg that supports your retirement income objective. Here are a few good ones you might check out: A simple one from Vanguard or an advanced one from Bankrate.
As we’ve discussed, a higher rate of return will require more risk. So you will need to carefully balance your risk-return tradeoff. There is no right or wrong, one size fits all, risk-reward profile. Each investor will need to make his or her own decision.
Investment time horizon
The further you are from retirement, the greater the risk you can and should take. As we demonstrated earlier, a longer time horizon carries much greater probability that riskier investments will perform well. The closer you are to retirement, the less risk you should take.
Similarly, if part of your investment portfolio is earmarked for a major purchase such as college tuition or buying a home within a few years, those funds should be invested in shorter-term, less volatile assets such as money-market funds, CDs or short-term bonds.
Psychology plays an important role in successful investing. I have found from my own personal experience that it is tough to stay the course during major market downturns. This happened to me in 1987, 2001-2002 and 2007-2008. When everyone thinks the world is ending and the media are dramatizing the situation, it is difficult to maintain substantial allocations to risky assets that are plummeting in front of your eyes. In 1987 and 2002 I sold most of my stocks, only to miss the inevitable big market rebounds.
Finally, after learning those lessons, I re-read time-tested investment principles and my investment policy statement. As a result, I held almost all of my stock funds in 2008-2009. (Truth be told, I did trim my stock positions slightly, but was rewarded by the big market rebound in 2009 and beyond).
The other aspect of investor psychology relates to willingness to tolerate “tracking error.” Simply put, it can be difficult if you have a portfolio that is not highly correlated to a major market average such as the S&P 500 or Dow Jones Industrial Average. At the neighbor’s cocktail party they brag that their S&P 500 index fund went up 28% and ask how you did. You reply that your well diversified portfolio went up 12%. That’s tracking error. Of course, conversely, your portfolio likely outperformed the S&P and your neighbor’s riskier portfolio when the market dropped substantially. But that’s when your neighbor doesn’t want to talk about investing.
For more on this, William Bernstein provides a really good explanation in his book, “The Four Pillars of Investing.” He also illustrates it here.
The Four Types of Capital – No Portfolio is an Island
A recently discussed concept* in portfolio design is the idea that an investment portfolio should be viewed within the context of an investor’s four major types of capital:
- Human Capital – our ability to generate income from employment. This typically rises early in your life, then peaks in your prime earning years (40’s – early 50’s) and declines in your late 50’s through retirement.
- Pension Wealth – this includes company pensions and social security, which represent on-going, fairly reliable cash flows during retirement that complement investment related retirement income.
- Housing Wealth – Homes represent a substantial portion of wealth (an average of 25% of household wealth in 2011).** Housing can provide leveraged returns (via mortgage) on home appreciation but also concentrated risk. Imagine in the housing market drop of more than 35% from 2008-2012 that you owned a $500,000 house with only $50,000 in other assets. Your net worth would have dropped by $175,000.
- Financial Capital – These are your most liquid assets, i.e. stocks, bonds, mutual funds, ETFs, CD’s, and money-market funds.
Here are a few simple examples of how your capital positions might affect your portfolio design:
- If you are still working past the traditional retirement age, are healthy and earning a substantial amount, and you plan to continue to do so, you might want to take more risks with your portfolio by owning more stocks.
- If you plan to have a combination of a pension and social security that covers a large portion of your living expenses, you might be willing/able to have a higher than average percentage of your portfolio in stocks.
- If you are in retirement and have low human capital (you aren’t not working) and low pension wealth, you might go with a less risky portfolio allocation since you have less certain income streams.
- If you have strong human capital, large equity and/or options in a fast growing publicly traded company, you might take less equity risk in your portfolio.
Every individual has a unique situation and must weigh all the factors, so this is not meant to be definitive investment guidance.
Consider other forms of wealth when you design your portfolio and don’t look at your financial capital in isolation.
Degree of portfolio diversification and complexity
Investors can choose from a range of portfolios, from simpler to advanced, based on their personal preferences. The degree of complexity will vary by the number and types of asset classes and sub-asset classes chosen. Here are considerations to help an investor decide:
- Number of asset classes. Investors can gain more diversification and better risk-adjusted returns by utilizing more asset classes, but that will also require more management time for rebalancing and tax optimization.
- The investor’s comfort and knowledge level with particular asset classes and specific assets.
- How simple vs. complex they would like to be; including management effort.
- Their profile in terms of types of capital they have.
- Their tolerance of tracking error. Advanced portfolios will have greater “tracking error.” As I discussed, this makes it tougher to stick with the less conventional strategy, leading to selling low and buying high, reducing the returns that should have been attained.
My Recommended Asset Weightings
Once you have addressed the factors above, you will be ready to decide how much to place in each asset class. Earlier I discussed which asset classes to invest in. So now the question becomes how much to put into each. The chart below shows data from various sources regarding the weighting of the world’s major asset classes.
Since the data are measured and depicted in different ways by different sources, they are inconsistent. Precision doesn’t matter though. The important thing is that this provides a world view of relative asset weighting to be considered when deciding on an investor’s portfolio weightings. A neutral or starting-point weighting of assets might be in line with the world asset-class weightings.
On the surface, you would think that would provide a somewhat neutral diversification level. However, it isn’t that simple. Various studies show the optimum levels of weighting of each asset class to balance expected returns vs. risk, cost and investment psychology considerations. An advanced approach is to use historical data and Modern Portfolio Theory to determine the best mix. Here is a paper about it if you want to go deeper. I won’t get into the details of all that, but below I provide my recommendations.
It should be noted that the weighting recommendations below constitute a form of “active management.” They will be somewhat different than what most “conventional” advisors might recommend. For example, many advisors will not recommend an allocation to gold and will typically recommend a higher weighting of US stocks than I do.
Recommended portfolio weighting (vs. the world and sector weightings):
- Slightly more (55-60%) US stocks than the world weight of about 50%. A Vanguard study shows that an allocation of 70% U.S. Stocks and 30% foreign stocks provides about 90% of the diversification benefit. By going with a larger than world U.S. weight, investors will reduce tracking error and costs. However, from the standpoint of what returns we might expect for the U.S. going forward, I believe a lower U.S. weighting is warranted.
- More value stocks, with an emphasis on small-cap value and international small-cap value. These categories have been higher performing than the average equity category over the long run, although there is debate as to whether this might persist.
- A higher than market weighting in commodity equities. This provides an inflation and declining-dollar hedge; also provides a diversification hedge given lower correlations with other stocks.
- More emerging-market stocks for higher potential returns, diversification and as an inflation/currency hedge.
- An allocation of REITs for diversification, income and potential inflation protection.
- An allocation to foreign bonds, with a mix of developed and emerging-market bonds at about 30% of the total bond allocation, for diversification, higher yield and a currency hedge.
- A significantly larger than “normal” allocation to cash for portfolio stability and safety. This recognizes historically low bond yields and duration risk, providing opportunity to take advantage of rising rates in the future without principal loss. Also provides flexibility for rebalancing.
- An allocation to gold and optionally gold mining stocks, to provide a currency, inflation and overall risk hedge.
Below are examples of “Lazy Portfolios” that utilize fairly simple and conventional assets. They do not take into account an investor’s investment plan. They aren’t recommendations; they are for illustrative purposes to show how such portfolios can provide good risk-adjusted performance over long periods, using easily accessible mutual fund vehicles. Each investor should carefully consider his or her needs, develop an investment plan and consider working with a financial advisor.
More information on the Lazy Portfolios is available from Market Watch.
For investors who prefer a more advanced approach, I provide model portfolio examples below. These portfolios utilize other asset classes beyond the “Lazy Portfolios” and have greater diversification and tracking error. The models utilize my recommended weightings indicated above. They also allow investors to make a choice based on risk-return preferences, with projected and past data provided to assist in that decision.
As indicated above, the decision is based on many factors, and each investor should carefully consider their needs and preferences, and may wish to consult with a financial advisor.
The model portfolio data below indicate that risk rises faster than reward as more equities are added. While these are imprecise forecasts, I believe they are directionally correct. Investors must choose where they want to be in the risk-return continuum.
The table below depicts specific holdings that I recommend. You can learn more about these holdings via a simple web search or using a good site like www.morningstar.com. Investors should carefully research their options for each asset type, and may wish to work with a professional financial advisor.
In the spirit of full disclosure, I hold positions or have recommended positions in most of these. I selected them based on various attributes:
- Use of index funds or indexed ETFs, with the exception of the bond category
- Low cost
- Good liquidity
- Substantial assets under management
- Valuation and outlook
- Track record
- Management-company track record
- Investment methodology
- For banks: yield, cost, access, financial strength and customer service
Note: The attributes/attractiveness of each holding may change over time and require periodic assessment and adjustment. This list is not meant to be exclusive or comprehensive, since there are many other viable options within each asset class. Each investor should carefully consider their specific investment options and whether to consult with a financial advisor before investing.