Finance 101: Part 5 – Beginning portfolio construction

Now the components of a saver’s portfolio have been outlined, let’s talk a bit about putting a few parts together.

Here are my fundamental principles for putting together my portfolio, at least, in order of priority:

  1. Don’t risk ruin.  I value sleeping well, so at no point could my investments go to zero or below.  That means (for those reading the extension lesson last time) never holding unlimited risk positions, keeping leverage at a reasonable level, and always holding a significant portion of cash.
  2. Diversification is king.  Hopefully I’ve convinced you by now.  I like having multiple types of return sources in my portfolio, so that my net worth doesn’t whip around like the stock market.  We’ve had the benefit of 2008 to learn that not all diversification is real (e.g. all hedge funds proclaimed they’re diversifying to equities, but that argument was proven very wrong).  This concept also means I need to keep on top of my investments, as sometimes what used to be diversifying is no longer.
  3. Minimise costs.  Market returns are extremely uncertain, but costs are completely controllable.  If I can achieve the same type of return stream with lower cost, I’m there.  BTW, I do still believe there are some superstar managers in super-diversifying sectors which deserve high fees; I just can’t afford them!
  4. Be lazy, yet systematic, as possible.  I would like a portfolio which requires maintenance (e.g. rebalancing) roughly once every few months.  I keep a picture of my desired allocation, and rebalance when necessary at those points.  That being said, I’m stretching the truth in my personal situation, as I’ve gone a few steps further.  But for the vast majority (99%+), having a relatively stationary portfolio is key.

So what are the basic ingredients for our beginning portfolio?

  • Cash: I am a subscriber to the idea of holding an emergency cash stash.  Opinions vary, but I would keep as much as needed set aside to feel comfortable if and when everyone in the family loses their jobs, and the financial markets are in the toilet.  Probably 3-6 months of expenses, with more if you live in an ‘at will employment’ country (e.g. the US!).  Advice for those working in the financial sector: keep more cash, as your job prospects are directly proportional to rising financial markets.
  • Equities: in particular, index ETFs.  They fit the points above perfectly – low cost, diversified, automatically rebalance.  Diversifying across geographies is a good idea – for example, US stocks are currently trading at a much higher valuation than the Rest of the developed world, so maybe worth buying some of the RoW.
  • Bonds/Treasuries: hmm.  Why do we usually have bonds in the portfolio?
    • They usually perform well (Treasuries, in particular) when stocks perform poorly.
    • They pay recurring interest – ‘carry’ is good, for the most part.
    • They have lower volatility than equities…mostly.
    • In sum, we should probably have some bonds in the portfolio.  However: remember that interest rates are near all-time lows, so carry isn’t too great, and  bonds can’t offset equity losses as well as in past.  I’m currently massively underweight bonds in our portfolio, replacing bonds with extra cash and a managed futures mutual fund.
    • I’d use ETFs instead of buying underlying bonds, given illiquid bond markets.

What proportions of each?  One of my favourite bloggers/fellow individual investors wrote a great post on creating a low-effort ETF portfolio, with the goal of equalising risk between equities and bonds.  A good start, methinks, for all the cash you don’t squirrel away in the emergency fund.

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