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Post #22 – Constructing a Simple Portfolio

In my last post, Post #21, I provided some thoughts for choosing your investment vehicle for holding your retirement assets. The main point of that post was, when choosing investment funds, it is best for the average retail investor to pick funds with the lowest fees (i.e., lowest management expense ratio). After choosing your family of funds for parking your retirement assets, the next step is to construct a simple portfolio.

We hear and read all the time about the importance of diversification and asset allocation. Up to this point in this blog I have mainly talked about allocating assets in only two broad classes; equities and fixed income. But these two asset classes can be broken down into more specific asset types to provide a little more diversification and, possibly, a little higher return.

Choosing asset classes is another area of the investment world where opinions vary widely as to what type of assets to include and what percent of your retirement assets should be invested in each asset type. I think this area of investing is too often made unnecessarily complicated. This complexity usually results from professional Wall Street investment advisors and money managers trying to maximize returns. However, the Wall Street professionals are usually catering to short term traders or high net worth individuals who are interested in returns better than the market average and are willing to spend the time and money to obtain better results. As a retail investor who, presumably, does not want to spend 60 hours per month managing their retirement investments, I think trying to “beat the market” is not a good use of your time or money. Remember, these Wall Street professionals charge big fees to try and beat the market averages. And, as previously indicated, the investment professionals’ results over long periods of time usually do not produce enough incremental return to justify their fees.

The point of this blog is to simplify, as much as possible, retirement planning. So I will try to simplify choosing asset types that will allow the typical retail investor to manage their portfolio in their spare time.

The two large asset classes; that is, stock equities and fixed income assets, can be broken down into many specific asset types. Examples of equity type assets are:

• Large growth US stocks
• Large value US stocks
• Mid-sized growth US stocks
• Mid-sized value US stocks
• Small company stocks
• Small company value stocks
• Large non-US developed market stocks
• Mid-sized non-US developed stocks
• Small company non-US developed market stocks
• Emerging market stocks (e.g., China, India, Brazil, Russia, Thailand, Turkey, etc.).

Examples of fixed income type assets are:

• Cash savings
• Bank Certificate of Deposits (CDs)
• US Treasury bonds
• Treasury Inflation Protected (TIP) Bonds
• US state/municipal bonds
• US corporate bonds
• Non-US corporate bonds
• Emerging market bonds.

Additionally, each of these fixed income types is also grouped into a “length of maturity” category; Short-term bonds (roughly 1 to 3 year maturity), intermediate-term bonds (approximately 4 to 10 year maturity), and long-term bonds (greater than 10 year maturity).

There are also other “alternative” asset classes such as real estate, precious metals, commodities, and energy.

The thinking behind diversifying your assets is that when you invest in many different type assets, at any one time, some assets will decrease in value and others will increase, thereby balancing each other out. This brings stability to your portfolio. There is a lot of history to support this thinking. I believe one can construct a simple portfolio that is easy to manage and will still provide this diversification benefit.

Is it really necessary to include all the asset types listed above in your portfolio? Many professional money managers say YES, but I say NO. There is nothing wrong with investing in most or all of the asset types listed above, but, in my experience, people who invest in lots of asset types will spend a lot more time managing their investments and in the end, likely, will not do significantly better.

Let’s look at an example of a simple portfolio. From previous posts you learned to select an equity allocation that you are comfortable with. This is always the first decision you make when constructing your investment portfolio. Let’s assume you have chosen 60% equities and 40% fixed income. Keep in mind that equities are any asset where the price can fluctuate. The fixed income category is assets where the price does not vary. Fixed income assets are supposed to be the stable part of your portfolio, i.e., your safe money assets.

My simplified portfolio starts out with 4 categories: US stocks, International stocks, Short-Term (ST) bonds and Long-Term (LT) bonds (I include intermediate bonds as part of the LT bond asset type). NOTE: when speaking broadly about fixed income assets, assuming you are not talking about junk bonds (which I never invest in), the bond “length of maturity” is more important than the issuing organization as interest rate risk, generally, is of greater concern than credit quality risk. The longer a bond’s time to maturity, the greater the interest rate risk.

For the simplest portfolio, two of these categories are equity assets and two are fixed income assets. My beginning simple portfolio would include these 4 asset types in equal proportion within their asset class. Figure 1 illustrates this simple asset allocation based on a 60% equity allocation.

Figure 1

The two equity types, US Stocks and Int’l Stocks, are split evenly within the 60% equity allocation and the two bond types, ST and LT bonds, are also split equally within the 40% fixed income allocation. The two stock asset types shown in Figure 1 maintains your 60% equity allocation based on your risk preference, but the addition of international stocks and LT bonds provides more asset diversity and, possibly, more return.

Figure 1 is just a starting point. The two equity asset types and the two fixed income types can be adjusted slightly based on your risk appetite. Let’s say that the higher volatility (with corresponding higher expected returns) of international stocks and LT bonds puts your overall portfolio volatility a little outside your comfort zone. You could make a couple slight adjustments to the portfolio allocations in Figure 1.

Figure 2 shows the simple portfolio where the percentage allocated to US Stock and ST bond asset types were increased somewhat. The adjustments in Figure 2 compared to Figure 1 lowers your portfolio volatility, but it also lowers your overall long term portfolio return slightly.

Figure 2

If you chose a different overall equity allocation, such as 70%, you would just shift the 10% increased equity percentage from the 40% fixed income portion of the pie and into the equity portion of the pie.

If your portfolio is nothing more than what is shown in Figure 1 or something similar like the adjusted version in Figure 2, your investment return and risk profile would do about as well as any of the more complicated portfolios advertised by brokerage houses or Wall Street professionals. Periodically “Re-Balancing” this portfolio would certainly be simple.

However, if one wants their portfolio to be even more diversified, it is easy to do so. Continuing to maintain your overall equity allocation of 60%, all you need to do is breakdown one or more of each of the four asset types in Figure 1 into more specific asset types. Figure 3 provides an example of a more complex asset allocation which breaks down each of the four asset types shown in Figure 1, into two more types for a total of 8 asset types.

Figure 3

The Figure 3 asset allocation is just as good as the simple asset allocation shown in Figures 1 and 2. The asset allocation in Figure 3 will provide even more diversity of your retirement assets. Therefore, theoretically, this more complex asset allocation should lower the overall portfolio volatility. This may be true, but I do not think the simple portfolios in Figures 1 and 2 will be significantly more volatile than the complex portfolio allocation in Figure 3. The majority of the volatility will be determined by your selected overall equity allocation percentage.

When it comes to constructing your retirement portfolio, this is really all you have to do. There are index funds or Exchange Traded Funds (ETFs) for all the asset types previously mentioned. To summarize, the three steps for simple portfolio construction are:

1. Decide what your proper equity allocation should be,
2. Select at least two asset types within each of the two broad asset classes (i.e., equities and fixed income),
3. Decide on the percent allocation for each asset type within the two larger asset classes but be sure to maintain your overall equity allocation you have selected in step 1 for your risk tolerance.

There are other alternative investments that can be added to any portfolio. I will discuss some of these alternative investments and how they might fit into a simple portfolio in future blog posts. I will also discuss some simple guidelines on how to make adjustments to a simple portfolio to increase your investment returns. But the simplified portfolio discussed above should be the basis of how you invest your retirement assets. Whatever version of the simplified portfolio you decide on, remember to periodically re-balance your portfolio to maintain your original asset allocation. When you perform your periodic re-balancing, you should adjust all your chosen asset types, not just the broader equity and fixed income asset classes.

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