Most of what you read on Smart Investor is a direct result of my own questions about and research into investing and this post on how to structure your investment portfolio is exactly that.
It’s born out of feeling bogged down by too many options and trying to decide what the perfect formula for my own portfolio might be.
If you really get into the weeds of this one you’ll find infinite rabbit holes to go down and a plethora of different approaches championed by different factions.
It’s the epitome of a head F***!
Being the conscientious type I’m here to solve that problem for you… before you find yourself deep in the maze not remembering the way back out.
I plan to do this by explaining what your key concerns should be and how you counteract them.
I do not plan on going into intricate detail on all the potential options because quite frankly others have already done it well and in minute detail. I will reference these where appropriate.
An Uncertain Future: Planning For What You Don’t Know
The problem of how to balance your investment portfolio really boils down to the fundamental issue that we can’t know the future with a high degree of confidence.
Anyone who tells you otherwise is either lying or truly misguided.
Like many times throughout history we are right now at an important economic junction. The pandemic has hit, we have endured, vaccination has begun and people are starting to look to what the future holds.
There’s potential for both deflation, inflation and even hyper inflation.
Different experts think different things.
After reflecting on (trigged somewhat by the latest Howard Marks Memo – Something of Value) the fact that many possible futures are possible… I know deep right… and then hearing Ray Dalio talk about diversification over and over again I had a bit of an Aha! moment.
My Aha! Moment: it’s not possible to know the future with much certainty so stop trying and try to create a portfolio that can perform well in as many futures as possible.
If that makes sense to you then I suggest you go forth and read about these two portfolios. Don’t worry if you don’t understand all that you read. Just Try.
Both options are designed to perform across a number of possible futures with a particular focus on minimising market volatility.
How To Diversify Your Portfolio Correctly
The next big issue we face when structuring a portfolio is diversification and what it really means.
- If you go out and put all your money into one company – you’re essentially all in.
- You can fix this by buying an index fund of the S&P 500 – you’ve now got shares in 500 companies but you’re still not really diversified because all these companies are US based.
- The next step is to replace that with the Vanguard Total World Stock Index Fund (VT) which spreads you out across hundreds of companies all over the world but you’re still now 100% invested into stocks.
- You go out and buy some bonds to balance your asset class allocations.
- What about precious metals, commodities, property, fine wine, art, Bitcoin… the list goes on and on.
Hence we are presented with the problem of diversification.
We know we need to be diversified to prevent over exposure (which brings with it greater risks when the market turns against us) but where does it stop.
Starting to see why it’s possible to feel bogged down? You can’t know the future and endless diversification options are available to you.
You may also feel positive about some of these diversification options and negative about others.
Case in point… Ray Dalio recently said that he doesn’t like the idea of holding government bonds any more, which in turn messes up his so called All Weather Portfolio and presents a problem for investors who wonder where to turn instead to get the diversification balance correct.
For what it’s worth Ray suggests looking at commodities, metals, and emerging markets instead.
All we can really know and say for sure is that we need our portfolio to be diversified between different asset classes and geos. We don’t know exactly what the future will hold but we do know if we’re diversified then we’re better prepared for it.
Volatility: How To Build A Portfolio To Protect Against It
Volatility is a common enemy for the majority of investors.
Simply because investors like to see their investments grow over time at a steady rate. They DO NOT like to see them fall and especially not a large amount all in one go.
Here’s a chart showing how vicious volatility can be. It details the biggest drawdowns (declines during a specific period) since 1970 for different portfolios:
As you can see some of the portfolio’s I mentioned earlier did best at mitigating against the biggest market declines.
What do these portfolios have in common?
They have a diversified range of assets in them outside of just stocks.
You might be wondering what happens to these portfolios during times when the market performs positively… here are annual growth averages since 1970:
- All Weather (Seasons) 5.7%
- Permanent 5.2%
- Larry 5.3%
- Golden Butterfly 6.5%
For a comparison if you were 100% invested into a total market fund you could would have averaged 8.3% annual over the same time period.
Source: https://portfoliocharts.com/portfolios/ (data taken from each specific portfolio page).
To protect against volatility we must sacrifice some upside. How much you want to do that depends on your own attitude towards risk and your own circumstances.
General Rule 1: The younger you are the higher your tolerance to risk should be as you’ve got plenty of time for the market to recover. The older you are the less volatility you want to be exposed to because, sorry to be morbid, you may never benefit from future recoveries.
General Rule 2: The more exposure to stocks you have as a percentage of your overall portfolio the more you’re going to ride the waves of market volatility.
What’s The Perfect Portfolio Structure Then?
Honest answer… there isn’t a one size fits all option. If there was everybody would be using it and I doubt I’d ever have written this post.
I hate it when there’s no answer because that always just leads to more questions.
There are however some key concepts that make sense to me having conducted my research and it’s these concepts I use to put my own investment portfolio together.
Key Points: How To Structure An Investment Portfolio
- More allocation into stocks means more volatility.
- Less allocation into stocks means sacrificing some potential returns.
- The younger you are the more tolerance to risk you should be willing to accept.
- To avoid your fate being tied to one company, sector, asset class or geo you need to own lots of them.
- The direction I believe the future will go is likely much less important than first thought… in fact it’s a question I often need not be able to answer.
Ultimately… what matters more than anything is that when you invest you do so accepting there will be good times and bad times but to get the upside you’re looking for you will have to hold your investments for a long period of time. As long as you understand how your portfolio is structured and short terms results shouldn’t really matter.
If you’re interested you can check out my actual portfolio here.