Assembling an investment portfolio is mostly a mechanical process comprised of several distinct steps:
- Choose an investment strategy: passive or active
- Allocate money to asset classes
- Select specific investments within each asset class
- Monitor & rebalance your investment portfolio
These steps are described in more detail, below. Even more detail is available in the forthcoming Pillars of Wealth Book 3: Investing Basics for Doctors.
Choose an Investment Strategy
The first step in the investment process is to decide whether to follow an active or passive investment strategy. If this was a book aimed at finance specialists or MBA students, both strategies would be on the table. But active investing only makes sense for those who commit a lot of time on a daily basis to investing and continuously have their fingers on the pulse of markets. If you’re reading this book you likely have a full-time job in the field of medicine or some other professional area and you don’t have the time or inclination to constantly monitor investments whose values move hour by hour or minute by minute. Accordingly, going forward in this book I assume we are all committed passive investors.
Allocate Money to Asset Classes
The next step in the investment process is Asset allocation. Asset allocation is the process of deciding which asset classes to put money into and in what proportions. Asset Classes were defined earlier in this chapter.
Suppose you have a total of $500,000 to invest in stocks and bonds. Your asset allocation may look like Figure 10.
Figure 10: Generic Asset Allocation
|
Asset Class |
Dollar Allocation |
Percentage Allocation |
|
Large-Cap Stocks |
$120,000 |
24% |
|
Mid-Cap Stocks |
$60,000 |
12% |
|
Small-Cap Stocks |
$60,000 |
12% |
|
International Stocks |
$50,000 |
10% |
|
Emerging Market Stocks |
$35,000 |
7% |
|
US Government (Safe) Bonds |
$75,000 |
15% |
|
Domestic High-Yield (Risky) Bonds |
$50,000 |
10% |
|
International Bonds |
$25,000 |
5% |
|
Cash |
$25,000 |
5% |
|
TOTAL |
$500,000 |
100% |
Your particular allocation should reflect your comfort level with risk. If you have a low risk tolerance you would hold more safe bonds and cash and lower allocations to high-risk stocks. If you have a high tolerance for risk, you would hold more stocks and fewer bonds.
Advisors will sometimes provide asset allocation tables with several decimal points of precision. Don’t believe it. They have far less precision in practice. Those extra decimal points in your asset allocation are meant to give the impression that a highly scientific process has taken place for which you must be charged a lot of money. In reality, the inputs to asset allocation algorithms are sufficiently affected by errors and estimates to render such suggestions of precision somewhat meaningless.
In practice, you can do reasonably well without a detailed asset allocation plan. A basic rule of thumb is to allocate a percentage to stocks equal to 100 minus your age. According to this rule if you are thirty-five years old you would allocate 100 – 35 = 65% to stocks, as in Figure 11.
Figure 11: Basic Asset Allocation
|
Asset Class |
Dollar Allocation |
Percentage Allocation |
|
Stocks |
$325,000 |
65% |
|
Bonds |
$150,000 |
30% |
|
Cash |
$25,000 |
5% |
|
TOTAL |
$500,000 |
100% |
Rules of thumb should not be treated as gospel. If you’re young you can probably allow yourself a more aggressive allocation to stocks, as in Figure 12.
Figure 12: Aggressive Asset Allocation
|
Asset Class |
Dollar Allocation |
Percentage Allocation |
|
Stocks |
$425,000 |
85% |
|
Bonds |
$50,000 |
10% |
|
Cash |
$25,000 |
5% |
|
TOTAL |
$500,000 |
100% |
Over time, the general idea is to gradually reduce your stock allocation to a more conservative posture—higher exposure to bonds and lower exposure to stocks—such that by the time you near retirement most of your money is in conservative bonds. Depending on your circumstances you could elect to retain significant stock market exposure in later years, with a view to bequeathing those stock holdings to your spouse or children.
If you elect the conventional path to gradual reduction of portfolio risk, you can use target date funds (TDFs). TDFs, also known as age-based or lifecycle funds, automatically adjust your investment mix as you age and near a specific target retirement age. Target date funds tend to charge higher management fees than some of the individual funds they invest in, so you could purchase the individual funds yourself and gradually alter the mix over time, thereby saving some money.
With interest rates at historically low levels, the expected return on bonds is very low. This has prompted investors to reduce bond allocations and place more money in stocks. Such a move can be reasonable but it comes with higher risk, as a nest egg more heavily weighted toward stocks will be more volatile than one wih a more balanced allocation across asset classes. The higher allocation to stocks tends to make more sense if you have a long investing horizon (decades) but the approach is less advisable for any funds you anticipate needing over a shorter term.
The next step in the investing process is to choose the actual investments in each of the asset or sub-asset classes.
Select Specific Investments Within Each Asset Class
Asset selection is the process of identifying and buying the actual investments for your portfolio. The investments may be individual stocks or bonds. For example, you may decide to invest directly in companies such as Microsoft, Google, Apple, Netflix, etc., or in bonds issued by companies such as Ford or General Electric. Individual stocks are recognizable by their unique Ticker Symbols. The symbols usually consist of one to five letters. For example, AT&T’s ticker is the letter T, General Electric’s is GE, Microsoft’s is MSFT.
If you opt to select individual securities such as stocks and bonds, you must research each of these companies separately, which can mean a significant time commitment. If your portfolio ends up invested in just five companies, you will also be exposed to significant risk if any one of those companies falls on bad times.
A much more efficient approach is to invest in pre-packaged funds that invest in pools of companies. Such funds (mutual funds or exchange traded funds), or more precisely the people who work for them, do all the work for you. They decide which stocks and bonds to buy and they create ready-made portfolios you can invest in directly. In addition to the convenience of having a portfolio selected for you, when you buy funds that invest in hundreds of companies you usually get diversification benefits.
Funds are identifiable by their unique ticker symbols. For example, BND is the ticker for a Vanguard bond exchange traded fund, and FLCSX is the ticker for a Fidelity Large-Cap stock mutual fund.
As a passive investor, simply buy one or two index funds within each asset (or sub-asset) class listed in your asset allocation. Look for Index funds designed to track easily identifiable indexes of stocks or bonds. For example, the SPY exchange traded fund (ETF) tracks the S&P 500 Index of Large Cap US stocks.
The advantages of index tracking funds are that very little energy is expended by the managers of these funds because they simply purchase stocks or bonds held by the index. Since index holdings are stable, very little trading is needed to maintain funds over time. These factors explain why management fees on such funds are so low. Finally, because there is little trading, there are also fewer tax realizations, which can help when investments are held outside tax-deferred retirement plans.
A simple way to find ETFs is to use filters or screeners provided by sites such as Seeking Alpha, Yahoo Finance or US News and World Report. These sites allow you to screen thousands of ETFs based on your preferred criteria (asset classes, fee ranges, fund sizes, etc.)
For example, the Vanguard S&P 500 ETF, identified by the symbol VOO, tracks the S&P 500 Index, while the iShares Core U.S. Aggregate Bond ETF, AGG, tracks the Bloomberg Barclays Aggregate Index of mostly high-quality domestic bonds.
Value, Growth, and Bear Funds
As you search for funds you may encounter the words “value” and “growth” in some fund names. Value funds invest in stocks that appear to be underpriced by the market based on a variety of fundamental financial metrics. Growth funds invest in stocks of fast-growing firms with potential for continued high growth. For the broadest diversification you should hold index funds that track the movement of all stocks in an index, including those that might be considered growth or value styles. Balanced funds invest in a combination of stocks and bonds, and sometimes also in money market holdings. The mix is usually stable, and often around 60% in stocks and 40% in bonds.
If you come across the word “bear” the fund is designed to do well when markets experience value declines. The words “2x,” “3x,” or “leveraged” indicate the fund utilizes derivatives and debt to magnify its returns. Avoid investing in bear and leveraged funds. They should only be used by professional investors and even then only over a short period of time.
Fees
Fees are a very important consideration when selecting investment funds. High fees eat away at your returns and can be very costly to your nest egg over extended periods of time. As we observed in the earlier time value of money discussion, even seemingly small fees of only 1% or 2% annually can have devastating effects on your total wealth. A 2% annual fee on investments over 30 years reduces your nest egg by 31%! That’s a staggering number. A 1% fee can reduce total wealth by 17%. Even seemingly small fees add up. Mutual funds may charge management fees, trading fees, and marketing (12b-1) fees. In addition, your advisor may charge his own fee for managing your money and helping to select investments. It’s quite common to end up with total fees well over 1%.
Because fees can have such a negative impact on our nest eggs, it’s crucial to minimize them at every opportunity.
I’m often asked the question: What’s a reasonable fee to pay for investment funds? There are many passive indexed ETFs with fees under 0.10% (a tenth of a percent). These are good fees. A fee of 0.20% is still quite reasonable. As the fees climb, more of your nest egg gets eroded, so the name of the game is to zealously reduce fees, and always keep on the lookout to lower them even further. By the time you get to fees of 0.3% and above you can almost physically feel your wealth draining away. Fees of 1% are outrageous, and in my opinion fees of 2% or more on standard investments should be considered criminal. For the record, they’re not.
Monitor and Rebalance your Investment Portfolio
This brings us to the final step in the portfolio assembly process. Over time the values of your investment holdings will change. Some will appreciate while others depreciate, drifting away from your originally specified asset allocation percentages. Periodically, usually once a year, you should examine your portfolio holdings and bring them back into balance by selling some of the ones that appreciated in value and buying more of the ones that declined in value.
There is no need to obsess over this. The percentage allocations need not precisely match your original weights. Given the errors that go into the allocation calculations, remaining within a few percentage points is sufficient. Advisors will often provide you with tables showing recommended allocation percentages along with tolerances indicating permissible drifts, as shown in Figure 13.
Figure 13: Asset Allocation with Tolerances
|
Asset Class |
Dollar Allocation |
Percentage Allocation |
Allocation Tolerance |
|
Large Cap Stocks |
$120,000 |
24% |
±5% |
|
Mid Cap Stocks |
$60,000 |
12% |
±3% |
|
Small Cap Stocks |
$60,000 |
12% |
±3% |
|
International Stocks |
$50,000 |
10% |
±2% |
|
EM Stocks |
$35,000 |
7% |
±2% |
|
Domestic Safe Bonds |
$75,000 |
15% |
±3% |
|
Domestic HY Bonds |
$50,000 |
10% |
±2% |
|
International Bonds |
$25,000 |
5% |
±2% |
|
Cash |
$25,000 |
5% |
±2% |
|
TOTAL |
$500,000 |
100% |
|
Advisors prefer to position these tolerances as giving them flexibility to be opportunistic on your behalf if they feel your portfolio should be tilted more into certain asset classes at a given point in time. In fairness there is some truth to this claim. What advisors don’t like to admit is that these tolerances are also a reflection of the imprecision in their original allocation recommendations. Wider tolerances also mean they can wait longer before being obligated to rebalance your portfolio, which means they can spend less time on you and more on finding other clients.
