We’ve done the theory, now the practice! Your investments in aggregate are called your investment portfolio. Different peoples investment portfolios can be wildly different, from one guy who only owns a single high risk biotech stock to the girl who owns only US treasuries, and everything in between.
The first step when designing a portfolio for you, is to figure out a couple of key questions:
1) How much money can you afford to put into the market?
Never invest money you can’t afford to lose, even if, with a diversified portfolio, the chances of you losing everything are almost 0.
Its a good idea to always leave a couple of months expenses in cash, just in case you need liquid assets and the market happens to crash at exactly that time (its always pours when it rains…).
2) How much risk can you take?
All the risk, all the time – I would love to bungee jump every weekend if I could.
A lot – Risk makes me feel alive, I get bored otherwise.
Some – I like to walk on the wild side sometimes, keeps life interesting.
A little – the possibility of losing even 10% of my assets makes me reach for the Haagen Dazs.
How much risk do you want to take?
This sounds similar to the second question but is very different.
If you need to retire in two years, you can’t take much risk, but there are plenty of 60 year old with very aggressive portfolios.
On the other hand, there are twenty seven year olds with all their savings in a cash savings account earning almost zero. Its a wasted opportunity.
What’s your time horizon to when you need the money?
The longer to when you need the money, the more risk you can take.
If you’re thirty and are saving for retirement, you can be take on rather a lot of risk, as the time until retirement (hopefully sub-20 years from an FI perspective) is fairly long. This gives a lot of time for your assets to bounce back from any crash.
Conversely if you need the money in the near future, then its a bad idea to take on a lot of risk, just in case asset prices crash just when you need the money.
So how does this relate to my investments?
The answers to each will inform you as to what your assets should sit in. As a reminder from the “Investing – A beginner’s guide to the markets” post, the higher the returns, the higher the risk. From riskiest to least risky (of the major asset classes) is as follows:
- Small capitalisation equities (small companies you can buy shares in)
- Large capitalisation equities (large companies you can buy shares in)
- High yield bonds (bonds issued by low creditworthiness companies)
- Investment grade bonds (bonds issued by big creditworthy companies)
- Government debt
So, from a very general perspective, the more risk you’re comfortable taking on, the more equities you should buy and the fewer bonds, and vice versa. In fact, there’s a general rule of thumb for this (for more details, I can recommend this excellent article on Morningstar).
Rule of thumb #1 :100 minus your age in equities
This rule is arguably one the most famous in finance (competing only with “a line that goes up is better than one that goes down” and the Rule #2 below). The idea here, is that you take 100 % and minus your age, giving you the amount you should be invested in equities. So if you’re 40, you should have 60% in equities (both large and small cap) and 40% in bonds. This has worked well for years, ensuring that those who are young get, on average, as much return as possible, but with lots of volatility, while those who are older get less return but less volatility too (bonds have historically been good at reducing volatility).
Nowadays though quite a few people argue that the 100% should become 120% (so a 40 year old would have only 20% invested in bonds) given bond yields are so abysmally low. I would agree with this. Personally, I have almost no bonds because I can from a monetary and psychological standpoint (I sit at the ¨A lot¨ end of of the risk spectrum), take a big fall in my assets, knowing it’ll rise back up in time. Its also a long time until Ill likely be able to retire (though hopefully not too long, hence, you know, the whole point of this blog).
Rule of thumb #2: Diversify your portfolio to boost returns and reduce risk
This makes intuitive sense, not only do assets move more or less when the market does (bonds move less, equities more) but sometimes they even go in opposite directions, gold was historically famous for this, when everything else went to shit, gold stayed stable or went up (i.e. acted as a hedge).
In other words, diversification acts as an insurance policy. By buying non-equity assets (whether that be bonds, property, gold or commodities) you’re likely losing some return, but the volatility of your portfolio will be significantly reduced. However, like any insurance policy, it has a cost, the returns.
Its also an inexact science, in the COVID market crash last March, gold very capably crashed just when equities crashed. As did bonds. As did everything except arguably property, because its hard to value (and therefore hides falling prices well). Which… wasn’t great.
The key point here is that at least some diversification is a good idea. Keeping all your life savings in a single stock may make you really good money. It may also completely destroy your life savings. If you really want to hold single equities rather than tracker funds, then at least 12-15 is the minimum number of holdings. If one does super well, you won’t make crazy money, but if one does super badly you won’t lose everything. Insurance policy, lose a little upside, but gain on the downside.
A final note, if you’re going to diversify, don’t half ass it. A grand in bonds doesn’t hedge one hundred grand in equities.
At the end of the day, this post barely covers the beginnings of diversification and portfolio design, we’ll dive into both in detail, as well as bring in the other asset classes (like property and commodities) in a future post. I look forward to seeing you then.