Creating your own investment portfolio or strategy boils down to a few key principles. The key topics we’ll cover in this article include tax-efficiency, time horizon, assessing risk tolerance, and diversification. Once you have a solid understanding of how these topics apply to your situation, creating a customized portfolio in pursuit of your goals can be relatively straightforward. Keep in mind, everyone’s situation is different, especially for more complex situations, portfolio design can/will include several other factors.
Creating an Investment Portfolio
Below, we’ll talk about some necessary steps to create an investment portfolio.
Consider Tax-Efficiency
When designing a taxable portfolio, meaning non-retirement accounts, investors have to consider their current tax situation. Taxable accounts are subject to taxes in the year that capital gains are realized or dividends and interest are paid. Therefore, if an investor is in a relatively higher tax bracket and/or in a state that has an income tax, it’s important to use investments that are tax-efficient.
For example, in states such as New York where state income tax is a concern, using municipal bonds to shield interest from state and federal incomes taxes is likely going to be more beneficial than using corporate bonds which don’t get the same tax treatment.
Another example is investing in securities with zero or low dividend payouts. Doing so will avoid dividends and therefore tax consequences as opposed to investing in high yielding or high dividend securities such as REITs. Instead, the investor could allocate their REITs in their retirement accounts, which defer taxes and therefore are favorable for holding higher-yielding investments if it’s necessary to shield that income. Likewise, an investor shouldn’t hold municipal bonds in a retirement account because they’re not getting tax benefits for doing so since the account itself is already tax-deferred the municipal bond income is already being shielded from federal and/or state income taxes.
Being tax-efficient with initial portfolio design is a key building block that will help you understand where to start and which type securities to avoid and look for dependent upon the type of account.
Understand your Time Horizon
One of the most important factors to consider that helps guide overall asset allocation and portfolio design is understanding your time horizon. Time horizon refers to the amount of time until you’ll potentially need to withdrawal or access the investments of the account for their intended purpose.
The most obvious time horizon for a retirement account such as a 401(k) is your target retirement age, also taking into consideration you have to wait until after 59 1/2 in most cases to avoid the withdrawal penalty. Let’s assume you’re 35 years old and wish to retire at 60. Your time horizon for the retirement account would be 25+ years. Knowing that you have 25+ years to allow the investments in this account to grow, it should be invested aggressively relative to other, short time horizon accounts.
For example, if you’re setting aside funds in a taxable account for a vacation home in the next 5-10 years, the investments in this account relative to the retirement account should be less aggressive. The sooner you’ll need funds from a particular account the less risk you should probably take. When it comes time to withdrawal from the account, you don’t want the day to day volatility of aggressive investments impacting your ability to achieve your goal of purchasing a vacation home. Instead, opt towards less aggressive investments the closer the goal becomes or the shorter the initial time horizon is.
Assess Risk Tolerance
Risk tolerance is a fancy definition to describe how someone responds to volatility in their portfolio. It’s near impossible to accurately measure or predict. In my opinion, nobody knows how they’ll react to a bear market if they’ve never experienced one before. That’s why I find it important to educate people and pre-emptively have a plan IF a bear market/recession were to occur.
If we know a particular accounts funds aren’t needed until retirement, we shouldn’t fret if the markets are down 20% this year because we have another 25+ years to recover. And while historical returns aren’t an indicator of future returns, it can provide context as to how markets have trended up over time. With this knowledge, does it impact someone’s ability to stomach risk? In my opinion, education, and knowledge of investing DOES increase someone’s ability to stomach risk because they have a better logical foundation to combat their emotional and oftentimes counterproductive decision making.
Risk tolerance is a hard trait to measure, but important to consider in portfolio design because it influences overall asset allocation. If you’re someone who certainly cannot bear a 10% or greater decline in your portfolio, then it makes sense to tilt the portfolio towards a less aggressive allocation. Whether that’s holding more cash in an emergency fund, or using fixed-income investments such as bonds to dilute the volatility.
Lastly, there are several tools and questionnaires available to gauge an investors risk tolerance with their own proprietary scoring method. While understanding how the scoring method works is important, focusing on the questions they ask and asking yourself how you’d actually react and feel is key to understanding your own risk tolerance.
Diversification
The final key component of developing an investment portfolio is diversification. Diversification is key to investment selection and overall asset allocation across all your investments. In order to build a properly diversified portfolio, an investor has to include asset classes that are non-correlated to one another.
For example, the US stock market can be broken into several different underlying sub-categories. Those categories could be market capitalization, meaning large companies versus small companies. Or, sectors such as technology, healthcare, consumer staples, utilities, real estate, etc. If an investor were to only own investments in the large-cap technology sector you can assume they’re likely not well-diversified relative to someone who owns investments across all US market caps and sectors.
You might ask, why is diversification important? If we assume that markets are unpredictable in the short-term, which academic research has continually shown to be true, then the vast majority of time investors aren’t able to pick and choose which investments will perform best on a year to year basis. Therefore, in order to “smooth” out the ride and provide more consistent returns, investors diversify their investments across market caps, sectors, geographical regions, countries, etc. The table below is one of my favorite depictions of why diversification is important and how on a year to year basis different asset class returns can vary significantly.
Benchmarking Your Investment Portfolio
Many investors want to know how their portfolio performance compares to a benchmark, indices, or other investors. My guess is it’s an innate human tendency to compare and contrast investment portfolios, yet what’s often overlooked is what truly matters: performance relative to the ability to achieve your desired goals. For instance, what does an annualized rate of return of 12% per year do for you if you run out of money at age 60?
Portfolio performance is not the issue in this instance; it’s likely spending above your means and/or not having a high enough savings rate throughout your working years. However, an individual or family who saved adequately and spent within their means, with an annualized rate of return of 7% and the ability to spend freely through retirement, will have achieved their “benchmark.” In this article, I will explore how we view portfolio performance relative to a benchmark and how it ties to everyone’s unique goals.
Benchmarking Relative to Indices
In the past, financial advisors who primarily provided investment management services without regard to financial planning or helping clients with the plethora of different areas of their finances that a modern advisor now assists with would likely have used underlying indices to benchmark their performance against.
At the time, the value provided by the financial advisor was focused solely on investment management and helping clients earn as much money as possible within the construct of their “risk tolerance” or agreed-upon asset allocation.
For example, let’s use the instance of a married couple who wishes to retire by age 65. They’re currently 40 and have an investment portfolio of $1,000,000. The financial advisor knows they have 25 years to invest until they start distributions from their portfolio to support their lifestyle.
After several discussions or completing a risk tolerance questionnaire (which is highly unreliable from our point of view), they determined the best asset allocation for their portfolio is 90% equities and 10% fixed income. Within the equity sleeve of their portfolio, the advisor recommends 70% for US equities and 30% for international equities. Within the fixed income sleeve, they recommend the US aggregate bond index.
What’s the best way to benchmark this portfolio’s performance when reviewing in future years? Would it be to compare the portfolio directly to the S&P 500?
The direct answer is a resounding NO! You cannot benchmark a portfolio of this makeup directly to the S&P 500 since it contains investments not within the S&P 500.
The S&P 500 is made up of the largest companies in the US, but doesn’t include small or mid-capitalization companies or companies that have a market capitalization of between 250 million and 10 billion. The US exposure in this mock portfolio would likely contain small and mid-cap exposure, so the benchmark should also include that exposure, not purely the S&P 500. Therefore, for the US equity sleeve of this portfolio, the benchmark should include the S&P 500, along with indices such as the S&P smallcap 600, S&P midcap 400, or others.
However, we can’t stop there. Since 30% of the portfolio is allocated to international stocks, the benchmark should also include indices for international equity.
Finally, the US aggregate bond index should also be included to wrap up the benchmark for the portfolio. Only then can the investor determine whether their investment advisor (remember, we’re purely gauging the value here based on investment performance, which many modern advisors provide far more value beyond investment advice) “outperformed” relative to their benchmark.
Outperformance relative to a benchmark can only occur if the portfolio uses individual stocks, weighting particular sectors more heavily than others, or using some “active” strategy that the underlying benchmark does not. As is often the case, however, this can also lead to underperformance. As information availability and high-frequency trading have become more prevalent, it’s become increasingly difficult to outperform using active strategies. SPIVA does an annual study of active versus passive, and the data suggests investors are far more likely to achieve their desired rates of return by using passive strategies and buying the indices rather than trying to outperform the underlying index.
Case in point: if you’re purely trying to benchmark your portfolio to an underlying index, make sure you’re building the benchmark using the various areas of the market you’re investing in. Otherwise, it’s disingenuous as to whether you’re over or underperforming the benchmark.
Benchmarking Relative to Goals
Let’s turn our attention to how the vast majority of investors should now benchmark their portfolios, which is to their unique goals. After all, what good is a 12% annualized rate of return if you’re still unable to buy that vacation home, retire at your desired age, or run out of money in retirement? Modern advisors will help their clients clearly define these goals and develop a portfolio asset allocation, required savings rate, and drawdown strategy to succeed holistically in their financial lives.
For example, let’s use the same scenario described above. We can also assume we’ve created a relevant portfolio benchmark to track performance relative to the underlying indices over time. However, in this instance, we’ll be tracking their annualized rate of return, savings rate, and other risk relevant to their ability to achieve their desired retirement goal of age 65. If, after 5 years, the portfolio has returned an annualized rate of return of 8%, but their financial plan uses the assumption of a 7% annualized rate of return, the clients are “outperforming” relative to their necessary rate of return required to retire at age 65 comfortably.
For simplicity’s sake, we’re not going to go into all the other nuances that advisors would advise on to ensure their plan is as bulletproof as possible. However, this provides a completely different reference point for benchmarking the portfolio.
Sure, it would be great if we could outperform the underlying indexes using some active management from time to time, but what ultimately matters is whether they can comfortably retire when and how they want. Instead, the portfolio should be optimized for risk management and tax efficiency, not trying to determine which area of the market will perform best year to year and making active decisions that would jeopardize their retirement goal.
Benchmark Your Portfolio Performance
It’s important to understand WHY you invest; only then can you clearly define your short—and long-term financial goals, which should ultimately be the benchmark for evaluating your investment performance. Don’t fall into the trap of trying to outperform the market or compartmentalizing your investment performance. Your finances are holistic and should be evaluated that way in almost all circumstances.
Create Your Own Investment Portfolio Today!
Learning how to create your own investment portfolio doesn’t have to rocket science. Through careful understanding of these core principles, you’re able to begin the process. Of course, the final step will include actual security selection. Whether you choose to use passive, low-cost funds such as index funds or ETF’s, or mutual funds or individual stock selection, keeping these principles in mind will certainly help guide you.
If you need assistance with portfolio design, aligning your portfolio with your goals, or overall financial planning advice, schedule a free consultation today!
*All written content on this site is for information purposes only. Opinions expressed herein are solely those of Millennial Wealth LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.
This website may provide links to others for the convenience of our users. Our firm has no control over the accuracy or content of these other websites.
