Setting up a sustainable, long-term investment portfolio isn’t as simple as picking a few blue-chip stocks and leaving it alone. The process is a thoughtful, holistic endeavor that requires weighing many variables from your life circumstances, planning out which assets to select, and setting some ground rules for success.
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Because each investor is unique in terms of goals, risk tolerance and age, there’s no boilerplate template for ensuring a successful portfolio. “What might be appropriate for a family, a couple, or an individual varies greatly from what might be appropriate for an endowment, a foundation or a pension plan,” says Sonya Mughal, CEO of wealth and investment management firm Bailard.
That being said, there are a few general guidelines and principles to follow that can help you get started on the right track.
When it comes to building an investment portfolio, experts recommend adhering to these steps:
1. Set an investment policy statement.
2. Figure out your asset allocation.
3. Avoid risky products and bad behaviors.
Investment Policy Statement
Your investment policy statement can be thought of as an instructional manual for what objectives your portfolio is intended to achieve, how much risk you’re willing to accept, and how long you have until you begin to make withdrawals.
Mughal describes it as “a customized road map that starts off with the individual’s assets, income, and expenses, makes assumptions about a rate of return, taxes and inflation, and provides a clear picture of how much risk the client should take for the portfolio to work.”
In general, an investment policy statement can be broken down into three basic elements:
1. Investment objective: This describes what the goal of your investment portfolio is. For instance, is it for retirement? A down payment on a home? A child’s college fund?
2. Risk tolerance: This describes how much of an unrealized loss you’re willing to endure in your investment portfolio. For instance, can you tolerate seeing your portfolio value drop by 20% during a stock market crash without panic-selling?
3. Time horizon: This describes how long you have until you begin to make withdrawals from your portfolio. For instance, if you’re 25 and plan on retiring at 65, you have a 40-year time horizon.
Asset Allocation
The investment policy statement will dictate your asset allocation, or the types of investment assets you select and in what proportions relative to each other. As Bryan Shipley, chief investment officer of investment advisory firm Arnerich Massena notes: “Your target asset allocation will be the primary determinant of your investment return and volatility going forward, so its importance cannot be underestimated.”
Different assets will have varying risk-return profiles. For instance, stocks historically have the highest long-term returns, but can be volatile over the short term. Bonds have a lower long-term return, but have lower volatility compared to stocks. Combining the two and other assets in varying proportions can create a wide range of risk-return profiles suitable for different investors. “Essentially, your portfolio’s asset allocation will act as the ‘guardrails’ to keep your desired level of risk and return on track,” Shipley says.
Investors should consider their investment objectives, risk tolerance, and time horizon holistically to determine their asset allocation. For instance, a 50-year-old investor with a six-figure portfolio planning on retiring at 65 might opt for a fairly balanced asset allocation of 60% stocks, 40% bonds. This ensures decent growth while mitigating some losses if the market crashes. An even older investor who just retired at 65 might opt for 40% stocks, 60% bonds to keep their portfolio value stable in anticipation of relying on withdrawals for income.
Investors have a variety of choices when it comes to assets. While buying individual stocks or bonds is possible, a better, easier way is to invest in mutual funds or exchange-traded funds, or ETFs. In exchange for an annual expense ratio, investors get the benefit of diversification, and don’t have to worry about managing their portfolios as much or keeping up to date with research.
[See: 7 Best ETFs to Buy Now.]
An even better option for an ultimate hands-off buy-and-hold approach is a target-date fund, which automatically optimizes asset allocation by age on a glidepath. For example, a 2050 target date fund would be suitable for investors retiring in 28 years. This fund will adjust its mix of stocks/bonds/alternative assets automatically as the years go by.
Finally, asset allocation can also be optimized for tax-efficiency. Rick Nott, senior wealth advisor at investment advisory LourdMurray notes that “taxes are the single largest free lunch that investors can give themselves, yet so many ignore it.” Some tips that he has include:
1. Holding dividend-paying U.S. stocks in a taxable account to take advantage of lower taxes on qualified dividends.
2. Placing international stocks in a taxable account to claim back a foreign tax credit on the amount withheld from dividends.
3. Placing income-paying assets like bonds or real estate investment trusts (REITs) in a tax-advantaged account.
4. Selecting stocks/funds with closely correlated yet different counterparts for tax-loss harvesting opportunities.
5. Holding assets with high distributions or high turnover (such as commodities funds) in a tax-advantaged account.
Avoid Risky Products and Behaviors
A perennial rule in investing is to “keep things simple.” A great example comes from John Bogle, the late founder and former chairman of the Vanguard Group. Bogle was a strong advocate for passive investing using index funds, and pioneered the “three fund portfolio,” which consists of:
1. A total U.S. stock market index fund;
2. An ex-U.S. international stock market index fund; and
3. An aggregate U.S. bond market fund.
On the other hand, products such as actively managed funds (where the fund manger attempts to beat the market by picking stocks), leveraged funds, commodities and derivatives are generally not recommended for most investors. These products carry unique risks that are suited for specific, tactical purposes, such as speculation or hedging. For a long-term buy and hold mentality, they may not be appropriate. From a fee perspective, they tend to have high expense ratios.
Finally, investment behavior can make-or-break a portfolio. The actions investors take, whether rational or irrational, can often have an outsized effect on their long-term returns. Here are some general tips on what types of behaviors to avoid:
1. Don’t time the market: Timing the market is difficult for even professional fund managers and can often result in missing out on rallies or buying in at the peak. Investors should try and “stay the course” and make consistent contributions regardless of whether the market is going up or down.
2. Don’t tinker too much: Your investment portfolio is like a bar of soap. The more you try and fiddle with it, the smaller it gets. Constant “optimizing” can result in excessive costs due to trading commissions and bid-ask slippage. “Don’t over-engineer your asset allocation,” Shipley says. “Most investors are best served by a simple asset class structure consisting of just a few broad asset classes, such as stocks, bonds and cash,” he says. Consider rebalancing your holdings just once or twice a year and revisiting your investment policy statement every few years.
3. Don’t rely on past performance: Buying a particular fund or stock based on strong historical performance is not a reliable way to ensure good future returns. Yesterday’s winners are often tomorrow’s losers due to mean reversion. A better way is to select assets for broad diversification and low fees, which are risk factors you can control.
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How to Build an Investment Portfolio originally appeared on usnews.com
Update 08/03/22: This story was published at an earlier date and has been updated with new information.
