How To Build An Investment Portfolio

When you’re putting together an investment portfolio two things are the most important: your asset allocation, and the fees that you pay. In my Fees: The Other F-Bomb post we dug into the topic of investment fees. Now it’s time to look at how to build an investment portfolio!

Asset Correlation

My apologies in advance!  To build an investment portfolio we’re going to take a quick journey into statistics and discuss something called correlation. This is just the degree to which different kinds of asset classes perform in relation to one another. Investors try and achieve a level of diversification in their portfolios. In the end, you’re searching for a combination of assets that maximizes your returns, while minimizing you losses.

Which means that you’re looking for a mix of assets that don’t move in sync with each other. So, when part of your portfolio is going down, you want another part which is expected to go up!

For practical purposes, think about things where investors typically run for safety. If stocks are going down investors get nervous and tend to run for the cover of government bonds. This dynamic is what’s “typical” and expected, although it doesn’t always hold up.

A hot sun correlates with ice cream and sunburn!

Causation and Correlation

Non-Correlated Assets

Let’s look at that relationship between stocks and bonds in a little more detail. In a previous post we talked about risk, and how bonds were in general less risky than stocks. This is because bonds are a loan to a company, while stocks are a piece of ownership in that company, which implies greater risk. In addition, bonds give you dividend payments (like interest payments) which also lowers risk.

But that’s just looking at bonds and stocks in general, versus together in a portfolio. Think about a simple two-asset portfolio: if the stock market as a whole is going down, investors in general will turn to bonds as a source of safety from the overall stock market decline. So, within your portfolio a portion of bonds has the effect of providing stability since while your stocks are going down, your bonds are expected to go up!

Asset Allocation

Then the question for you really is, how do you figure out which assets are appropriate for you to use in your portfolio, ideally using non-correlated assets? The mix of investments you choose to put into your portfolio is called Asset Allocation.

THIS IS BIG STUFF! There are tens-of-thousands of mutual funds and Exchange Traded Funds out there, all competing for your attention. And there’s no way for you to analyze all of them. So, to build a portfolio, start with the bigger picture that pertains to your situation: your timeline, your investment goals and your risk tolerance (are you sick of hearing me say this yet?). This will help you determine what asset types to use. And once you’ve got that figured out, only then do you determine which specific funds to plug into your portfolio.

I’m going to get a little wonky here and you can follow this link if you want more information. This is a pamphlet by The Vanguard Group that talks about the importance of asset allocation. But here’s the time-tested shorthand for asset allocation: finding the right allocation for your situation, filling in the funds that represent the assets you’ve decided on, and sticking with your investment plan over the long run are crucial to your success.

 

A chalkboard showing a pie chart of investment types

Asset Allocation is the mix of investment TYPES within your portfolio

Deciding Your Allocation

Knowing the importance of asset allocation, how do you determine which mix of investments is suitable to your particular situation? Again, at this point we’re not talking about individual investments yet, but individual types of investments like your mix of stocks versus bonds.

When deciding your asset allocation there are online tools available, mostly from different investment managers like mutual fund companies. In this case you can access an investment calculator by the Vanguard Group by clicking here. By using this online questionnaire you’ll get a recommended asset mix of stocks versus bonds, but not specific funds to use.

But once you have the mix of stocks versus bonds, what do you do with that? How do you determine which funds to use? That leads me to what we first discussed here…The Magic Four!

Interested in the types of funds that make up a simple, well-balanced portfolio? Sorry my friend, we just might have to wait a little bit longer to learn the answer!

Next time, I’m going to start focusing on Socially Responsible Investing (SRI), otherwise known as ESG (Environmental/Social/Governance) Investing. Because A: it’s the Holiday season, and B: it’s about time!

In the meantime, if you like these posts please drop me a line at andy@andyproctor.com. And better yet, drop me a line and pass this post on to a friend or two who you think may benefit from these insights!

Thanks so much for joining me this week and Happy Thanksgiving. I truly appreciate it!