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.
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 dependant upon the type of account.
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.
Assessing 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.
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.
The Bottom Line
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!
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Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. Levi’s been quoted in the New York Times, Business Insider, Forbes, and is a frequent contributor to Investopedia. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!