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How to Construct an Investment Portfolio

Last week, we touched on the importance of portfolio diversification.  This week, we will take our portfolio discussion a step further and review some pointers that will assist in proper portfolio construction.  This is important because most everyone has at least one investment portfolio (most commonly in the form of a work retirement plan), but too few know the basics of putting together a balanced portfolio.  I've witnessed firsthand how much excess risk (or even lack of risk) many investors are unknowingly taking in their accounts, so it's time we get a little more educated.  In an effort to do just that, let's review 4 fundamental concepts that will help lay the groundwork towards construction of a solid investment portfolio.

1. Review Your Time Horizon

First, know that investing in stocks and bonds should not be considered a short-term journey.  Stocks and bonds both have market risk, meaning you could potentially lose a significant amount of money in any given time frame.  Let's take a look into what that means.

Dating back to 1926, the average bear market (period of a 20% or more market decline from previous highs) of the S&P 500 has lasted roughly 2 years (see chart attached).  Let's assume the worst case scenario and say one invests 100% in the S&P 500 right as a bear market kicks into gear.  Considering a 2 year slide and an average recovery period of roughly 3.5 years, this investor should not expect to be back to even until year 5 or 6.  Being in a diversified portfolio could likely reduce this cycle, but I would still suggest that anyone with a 0-5 year time horizon keep their money out of the market entirely.

I've created a simple overview here below that lists which timelines warrant taking on investment risk.

Will your investable funds be needed within the following time frame?

0-5 Years:  Stay in cash/savings
5-10 Years:  Explore a Conservative to Moderate risk portfolio
10+ Years:  Explore a Moderate to Aggressive risk portfolio

2. Review Your Risk Profile

Once you've established your investment time horizon, you must now explore how much risk you can realistically handle as an investor.  This requires complete honesty.  An investment strategy is only as good as the investor's ability to be disciplined in its execution, so an incorrect evaluation of your risk tolerance can derail your potential for success before you even begin.  Here are the different portfolio risk tolerance profiles.  Which definition aligns most closely with your emotional convictions?  Again, because it's worth repeating, be honest!

Conservative:  Low risk tolerance, where the term risk means danger.  When making a financial decision, this investor tends to focus on possible losses.  Fluctuations in account value cause high stress.
Moderately Conservative:  Below average risk tolerance, where the term risk means uncertainty.  When making a financial decision, this investor is more focused on possible losses, but is also mindful of possible gains.  Fluctuations in account value cause mild stress.
Moderate:  Average risk tolerance, where the term risk means possibilities.  When making a financial decision, this investor is more focused on possible gains, but is also mindful of possible losses.  Fluctuations in account value are understood.
Moderately Aggressive:  Above average risk tolerance, where the term risk means opportunity.  When making a financial decision, this investor tends to focus on possible gains.  Fluctuations in account value are expected.
Aggressive:  High risk tolerance, where the term risk means excitement.  When making a financial decision, this investor only focuses on possible gains.  Fluctuations in account value are welcomed.

Review your time horizon, then apply the suggested risk profile which best describes you.  Once complete, you are set to move forward to the next step.

3. Develop an Asset Allocation

In layman's terms, this means that you will be creating one of those super sweet looking pie charts for your portfolio.  In order to do this, one must start from square one, which means first determining a baseline portfolio mix of stocks (equities) versus bonds (fixed income).  Remember from the prior post, stocks have quite volatile movements (more risk) but tend to generate higher long-term returns, while bonds usually have a more stable path and predictable returns (less risk).  Aggressive profiles should have more of an allocation to stocks, while conservative investors should have more exposure to bonds.

With your risk profile in hand (as determined in steps 1 and 2 above), use the chart referenced here to find your recommended stock/bond mix.  For example, a moderate risk investor should match relatively well with a portfolio that consists of 55% stocks and 45% bonds.  Of course, you can move up and down the scale as your wish.  This chart is simply here to give you a baseline starting point.

Now take a breather, because we still need to dig a bit deeper into this asset mix.  Sure, you could simply buy a broad U.S. stock fund for your stock exposure and a broad U.S. bond fund for your bond exposure and call it a day; however, we can diversify further to potentially generate better returns on our money.  Let's first take a look into further diversifying our stock holdings.

STOCK ALLOCATION

To get a better handle on what true stock diversification looks like, it makes sense to first take a peek into the total world stock market.  In other words, if you took one dollar and invested it across the entirety of the world's market, how would that dollar be split?  A company named MSCI tracks this world stock market for us in an index called the MSCI ACWI (All Country World Index).  I've included a pie chart of the index for reference.  Notice that the United States makes up just over 50% of the world stock market.  If you invested solely in U.S. stock funds (which a lot of people do), you would be missing out some exciting growth potential from international markets.  For this reason (and a few others too lengthy to review today), I would suggest that a better stock allocation in your portfolio should more closely resemble this chart.  The world stock market allocation recap is referenced here below.

U.S. Stocks:  53% of stocks
International Developed Stocks (Canada, Europe, Japan, etc.):  36% of stocks
Emerging Markets Stocks (China, India, etc.):  11% of stocks

BOND ALLOCATION

For further bond diversification in a portfolio, an investor can again choose to look internationally.  The chart referenced here by J.P. Morgan shows that the United States has only issued about 37% of the world's fixed income holdings, which appears to make a compelling case for adding international bond exposure.  Perhaps.  But one must first remember that arguably the most important function of bonds in a portfolio is to provide protection (think insurance) against the volatility of stocks.  It's that non-correlation factor that we discussed last week.  High-grade U.S. bonds do an excellent job of providing this protection, most times much better than international bonds.  And unlike equities, high-quality bond prices tend to remain fairly stable across most time frames, so the benefits of mass diversification in this sector are going to be somewhat muted compared to those same benefits expected in stocks.  For these reasons, a high-quality, U.S. broad market bond fund works perfectly fine for most investors; especially if simplicity helps keep you on target.  Parameters for a bond allocation mix are referenced here below.

U.S. Bonds:  37% - 100% of bonds
International Developed Bonds:  0% - 44% of bonds
Emerging Markets Bonds:  0% - 19% of bonds

4. Pick Your Holdings

With an effective asset allocation now understood, successful deployment of a quality investment portfolio is at your fingertips.  The last hurdle lies in deploying the actual holdings that will accurately embody the asset classes you are trying to represent.

To best assist in properly covering your bases, you should invest in funds (mutual funds and/or Exchange Traded Funds) and not in individual stocks or complicated alternative assets.  The latter will pose too much confusion and complication.  Remember, simpler is almost always better.  Also, try to target broad market index funds in an effort to reduce your investment expenses and increase the tax efficiency of your account.

Finding a fund to accurately represent each category can be tricky, so I'm giving you a quick and dirty reference list below.  When scouring the available investment options within your work retirement plan or personal investment portfolio(s), seek a fund within each sector that includes some form of the following verbiage.

U.S. Stocks:  S&P 500, Russell 1000, Total Stock Market
International Developed Stocks:  FTSE Developed, MSCI EAFE, International Developed
Emerging Markets Stocks:  FTSE Emerging, MSCI Emerging, Emerging/Developing Markets
U.S. Bonds:  Aggregate Bond, Total Bond Market, Total Return
International Developed Bonds:  International Aggregate Bond, Total International Bond, Global Bond
Emerging Markets Bonds:  Emerging Markets Bond, Emerging Markets Income, Emerging Markets Debt

If unsure about the strategy of a particular fund, you might have to roll up the sleeves and do a little digging.  You can do that by searching the fund in Morningstar and clicking on the "Portfolio" tab on the main page.  A full breakdown of the fund and it's holdings will be summarized for you.


Please note that this post is not meant to be an all-inclusive portfolio construction tutorial, as there is so much more we could delve into with a mind-numbing amount of detail.  Nor is this post meant to be personalized investment advice, as everyone's situation is different.  Rather, this commentary is simply meant to inform, educate, and help lay the groundwork for better all-around portfolio construction.  For specific advice about your own portfolio, please seek one-on-one guidance from a qualified financial professional.

Any further thoughts or ideas you would like to add?  Please feel free to share in the comments below!