Your portfolio design will depend on your need, ability and willingness to take risk with your investments. Taken together, these factors will influence your asset allocation decision and specific asset choices for your portfolio.
Your ability to take risk depends on your age, income stability, income sources and need for liquidity. Your willingness has to do with your psychological make-up, i.e. how comfortable you are with portfolio declines. Your need to take risk depends on your retirement income goals and level of savings.
Now let’s dive deeper into the elements of this dynamic:
- Target rate of return
- Risk tolerance
- Investment time horizon
- Investor psychology
- The Investor’s four types of capital
Target Rate of Return
In an ideal world, you simply determine what return you need to reach your retirement income goals and build a portfolio that meets those goals. You begin by identifying your retirement income goal ($x dollars per year), retirement date and planned savings. This can be fed into a retirement calculator using various return, tax rate, inflation and end date assumptions to generate a forecast and probability of success. By working with such a calculator, you can determine your required rate of return.
However, it’s not that easy. As we discussed earlier, return and risk are joined at the hip. They have an inverse relationship. Higher returns require higher risk taking. You can’t select one attribute for your portfolio without considering the other. What if the return level you select carries the risk that your portfolio might decline by up to 50% in one year? Will you be comfortable with that? Given the expected market returns, what if you can’t expect to achieve your target return from any mix of assets we’ve been discussing?
Your willingness to take risk has to do with your comfort level with portfolio volatility, particularly a decline in value. The table below depicts how the broad asset allocation decision between stocks and T-bills affects return and risk.
A 100% equity allocation has the highest return, but also showed the biggest decline of 41% in the 1973-1974 bear market. In the 2007-2009 bear market a 100% U.S. equity portfolio declined about 55%. However, a balanced 50/50 stock/T-bill portfolio averaged a respectable 7.35% per year for 99 years, while losing much less (15%) in the 1973-1974 bear market.
The data also show that the equity allocation is the biggest component in determining overall portfolio risk and return. This is because equities have high returns and high volatility over time. Bonds provide stability and lower returns. Therefore you should first decide the percentage you want to allocate to stocks. Determining the allocation to other asset classes and specific types of equities will follow.
The chart below provides a guideline or starting point for investors to weigh their willingness to take on risk. For example, if you can’t sleep well while your portfolio drops by more than 20% in a year, then you probably should limit your equity allocation to no more than about 50%, all other things equal (more on that below).
Vanguard also has a nice depiction that shows the risk-return trade-offs for various portfolio models across the spectrum.
Investment Time Horizon
Your ability to take risk depends on your age and how far you are from retirement. 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.
Generally speaking, younger investors will have lower savings and a long investment time horizon. Therefore they will also have higher return goals. This provides them the ability and need to take risk to reach their retirement goals. They may also be more willing to take risk, given they might not yet have been scarred by a bear market. They can also look forward to many years of income and savings to make up for any portfolio declines. All this allows them to be more aggressive investors.
Older investors, especially those who have saved and invested successfully, may be set up well to meet their retirement income needs. In that case, there may not be much need to take on risk. Also, if investors are at or near retirement, they have less time to recover from drops. They might also have immediate income needs that will have to be taken from their portfolios. In other words, they don’t have the ability to take risk, even if they are willing to do so.
Also, 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 it can be tough to stay the course during major market downturns. This happened to me in the 1987 and 2001-2002 bear markets. 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 stocks near the bottom, only to miss the inevitable big market rebounds. After learning those lessons, in 2008 I re-read time-tested investment principles and my investment policy statement. This helped me to stay on track with my long-term asset allocations.
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, balanced portfolio went up 14%. 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 relatively new 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 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 if during the housing market drop of more than 35% from 2008-2012 that you owned a $500,000 house with $50,000 in other assets. Your net worth would have dropped by $175,000 or 32%.
- 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 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.
Additional Insights: Morningstar: There’s More to Wealth Than Your Portfolio
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 re-balancing 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.” This makes it tougher to stick with the less conventional strategy. It could lead to selling low and buying high, reducing returns.
Below are examples of “Lazy Portfolios” that utilize index funds with varying levels of diversification across asset types. They show very good returns in all periods over the past ten years. However, as I’ve discussed earlier, I don’t expect to see such returns in the coming decade.
These portfolios don’t take into account an investor’s investment plan. Therefore, they aren’t recommendations. But they illustrate how a simple approach can lead to very good performance over long periods. The portfolios utilize easily accessible mutual funds and ETFs. You should carefully consider your needs and develop your own investment plan. You might also want to work with a financial advisor to assist you.
More information on the Lazy Portfolios is available from Market Watch.
Most investors will be well served to adopt a simple asset allocation strategy, similar to the Lazy Portfolios above. Regardless, it’s important to choose an allocation that balances your return goals and risk tolerance. However, more advanced and adventurous investors might wish to adopt a more refined strategy.
The chart below shows an estimate of a “global market portfolio.” This depicts the relative amount invested in all major asset classes worldwide.
While the data aren’t current (from 2012), they likely haven’t changed dramatically. The chart demonstrates some important points. First, equities and government bonds garner nearly two-thirds (65%) of all investments. The third largest holding is investment grade bonds at 19%. Alternative assets, including real estate, private equity, emerging markets bonds, high yield bonds and inflation protected bonds collectively represent about 16%. Note that gold isn’t shown here, but I have seen estimates of 1-2% of total world assets in gold.
Vanguard estimates that about 55% of the total world equity allocation resides in U.S. equities. The U.S. bond market, estimated at more than $41 trillion, accounts for about 40% of the world bond market value, according to the Bank for International Settlements (BIS).
The Vanguard paper, “The Global Case for Strategic Asset Allocation and an Examination of Home Bias,” shows that there is clearly a “home bias” with respect to investing. For example, U.S. investors place 79% of their equities in U.S. stocks, even though the world weighting is 55%. This is due to many factors, including return expectations, preference for the familiar, corporate governance, currency and others.
The chart suggests that a neutral or starting-point weighting of assets might be in line with the world asset-class weightings. In other words put about 35% of your money in stocks, 30% in government bonds and so on. On the surface, you would think that would provide a somewhat neutral diversification level.
However, it isn’t that simple. As I discussed above, investors have different goals and risk-return preferences. 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. Also, Research Affiliates has a slick website with free portfolio builder tools.
Here are some general guidelines that I follow for my own portfolio:
U.S. Equities vs. Rest of World. For the equity component of the portfolio, allocate the world weighting or less (i.e. 40-55%) of the stock portfolio to U.S. stocks and the rest to foreign equities. A Vanguard study shows that an allocation of 70% U.S. Stocks and 30% foreign stocks provides about 90% of the diversification benefit. However, valuations in the U.S. market as of this writing are near all-time highs. Based on this and other factors discussed earlier, I believe a lower U.S. weighting is warranted.
Value Stocks. Allocate more than the market weight to value stocks, with an emphasis on small-cap value, emerging market value and international small-cap value. These categories have been better performers over the long run, although there is debate as to whether that might persist.
Commodity Equities. Own a higher than market weighting of commodity equities. This provides an inflation and declining-dollar hedge. It also provides a diversification hedge given lower correlations with other stocks.
Emerging Markets Equities. Own a higher than market weight in emerging-market stocks for higher potential returns, diversification and as an inflation/currency hedge.
REITs. Allocate some of the portfolio to REITs for diversification, income and potential inflation protection.
High Quality Bonds. For the fixed income component of the portfolio, utilize only high-quality, short and intermediate term government and corporate bonds. This provides safety and optimum risk-return for your portfolio. This is discussed earlier.
Gold and Gold Mining Stocks. I believe all investors should own gold, with an allocation of 5-15% of their portfolio. Gold is a store of value. It provides portfolio diversification, protection from fiat currency debasement and protection during times of financial market stress. Investors might also wish to own gold mining stocks.
Cash. Consider allocating some of your portfolio (5-10% for example) to cash for stability and safety. This recognizes the high risks in today’s market, historically low bond yields and high duration risk. It also provides more flexibility to re-balance and acquire cheaper stocks or bonds in the event of declines in equities and/or bonds.
Please note that my recommendations constitute a form of tactical asset allocation. The recommendations will likely be somewhat different than those of many conventional advisors. For example, most do not recommend gold and will typically want a higher weighting of U.S. stocks than I do.
Evanson Asset Management makes a strong case for not employing tactical asset allocation. He uses a neutral weighting within equity asset classes.
Advanced “Unconventional Portfolio” Example
The table below shows an example of how to apply the recommendations I described above. I believe this somewhat unconventional portfolio has the potential for a better risk-adjusted return than more conventional portfolios such as the Lazy Portfolios. It employs assets that are not part of many conventional portfolios, including foreign REITs, MLPs and gold. It also tilts the weightings in certain sectors, including U.S. large and small value, emerging markets, international small cap and commodity producers.
Notable attributes of the example unconventional portfolio:
- There are many low cost index funds that allow an investor to access each asset class for their portfolio.
- The overall equity allocation of 59% is similar to Dr. Bernstein’s Smart Money portfolio above. This is a balanced type of portfolio.
- More than 50% of the equity position is in foreign stocks
- A 5% allocation to gold
- A 3% allocation to commodities equities
- A 3% allocation to MLPs
- A 3% allocation to small cap international equities
- A 3% allocation to foreign REITs
The returns are competitive with Dr. Bernstein’s Smart Money portfolio over the past one and three year periods. However, the Unconventional Portfolio trails the Bernstein portfolio slightly over five years (6.1% vs. 5.3%) and ten years (7.4% vs. 6.5%). This is largely due to the underperformance of international equities, commodity equities, MLPs, foreign REITs and gold. This is a good example of tracking error.
However, savvy investors might view this as a reversion to the mean opportunity. These assets can have appeal as out of favor, undervalued sectors. They may very well contribute to positive tracking error over the next five to ten years.
Note: The example portfolio above should not be construed as investment advice. Investors should thoroughly consider their goals, research their options and may want to work with a professional financial advisor.
Sample Investment Vehicles
The table below depicts specific sample holdings in each category. You can learn more about these at a good investing site such as Morningstar.
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; no actively managed funds
- Low cost
- Good liquidity
- Substantial assets under management
- Valuation and outlook
- Track record
- Management-company track record
- Investment methodology
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.