Overview on Portfolio Construction

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Pizookie!

Ok, so at this point you’ve gotten some finance basics under your belt.  You’ve gone ahead and minimized your life and finances, gotten rid of any credit card and high interest debt, created a budget, and are saving almost 20%.  Depending on your situation you should be maxing out your 401k (or 403b, 457, TSP) or contributing at least up to the match and now you might even have extra cash to also fund a Roth IRA (front or backdoor) and/or a taxable account.  Great!  Now it’s time to start thinking about investing and portfolio construction.

With a 401k or similar plan (i.e. 403b, 457, TSP) or a 529 plan, investment choices are usually limited and therefore there isn’t much you have to do to be invested.  Most of the time your money in a 401k can be put into a target date fund or something similar and in a 529 plan you’d most likely pick an age-based option.  However, with a Roth IRA, traditional IRA (tIRA), taxable account or ESA you have much more investment options available to you and that means you need to think about how to construct a portfolio.  But where do you start and how do you construct one?

First identify the goal and timeline for the money you’re investing.  Is it earmarked for retirement?  For a house purchase in the next 7 years?  Or a vacation?  Generally, any money goals you have that are less than 5 years out should be kept liquid, most likely in a high interest money market or online savings account.  Look for the best rate here at bankrate.com.  Incidentally, you should probably also keep you’re emergency savings in one of these accounts as well.

Next you should determine your risk tolerance which will then help determine your target asset allocation.  Determining your risk tolerance is another important part of determining how your money will be bucketed or allocated into stocks vs bonds.  Wells Fargo has a simple risk tolerance questionnaire here and Vanguard has an investor questionnaire here.  I’d take multiple tests if you can because I’ve gotten different asset allocations and risk tolerance depending on the questionnaire I took.

There’s also the age rule for portfolio allocation that states 100 minus your age is the amount you should invest into stocks and the rest in bonds.  So for example, if you’re 30 years old, 100-30 = 70, that means you should allocate 70% to stocks and 30% to bonds or short-term reserves.  But I think this rule is kind of outdated and tends to make a portfolio more conservative than it should be for your age.  That’s why some financial advisors now use 110 or 120 – age to determine the % you should invest in stocks.  For example, my asset allocation currently is about 10% bonds/cash reserves and 90% stocks and I’m 35 years old.  Please note though that my asset allocation is very specific to my risk tolerance, goals and situation.  For example, in determining my asset allocation besides my goal being retirement and my risk tolerance being high, we also took into account that I’ll be receiving a pension, 50% of my estimated social security and that I plan on working til at least age 67 years old.  I therefore believe that I can withstand to take a little more risk with my retirement investments because I’ll have a lifetime guaranteed income with a pension and my estimated social security payments are high.  Now if you don’t have a pension and/or you don’t believe you’ll get any or much social security at all then the picture for you will probably be different.

Also remember to keep your whole investment portfolio in mind.  Your money is most likely in multiple accounts.  You may have 2 401k’s, 1 current and 1 from a previous employer, a Roth IRA or tIRA, and/or a taxable account.  If you have a spouse, you have to also consider his or her accounts too!  When thinking about your portfolio, you have to remember that all these accounts together make-up your entire portfolio.  So if your target asset allocation is 80% stocks and 20% bonds, you have to make sure the entire portfolio reflects this asset allocation.  Let’s go through an example:

You have $150,000 in your 401k, $15,000 in your Roth IRA and $10,000 in a taxable account that is all earmarked for retirement.  Your recommended asset allocation is 80% stocks and 20% bonds.  How can all your accounts reflect this?  Well you could just make each account, 401k, Roth, taxable, be individually invested 80% stocks, 20% bonds like this:

tableThis is probably the simplest way to make your asset allocation align.  But nothing’s ever this simple because you also need to take into account what investment options you have or don’t have as the case may be and/or tax-efficiency!  Some investments are more tax-efficient than others.  As a general rule, tax-efficient investments (i.e. usually stocks) can be in any account, but tax-inefficient investments such as bonds, REITs should be in tax-advantaged accounts like a 401k or Roth IRA.  So let’s assume you’ll invest your 401k assets into a target date fund or something similar because you don’t have many options available in your 401k or just because it’s simple.  Choose a target date fund to match your desired allocation, in this case 80% stocks, 20% bonds/short-term reserves.  That leaves the Roth IRA and taxable account money which totals $25,000.  $20,000 (80% of $25,000) should be invested in stocks and $5000 in bonds.  As mentioned above, since bonds are generally tax-inefficient, we should place these funds first, since tax-advantaged space is more scarce.  $5000 of the $15,000 in the Roth IRA should therefore be invested in bonds and then the remaining $10,000 should be placed in stock investments.  The entire taxable account should be invested in stocks.  Now your entire portfolio comprised of 401k, Roth and taxable is allocated 80% stocks and 20% bonds.

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The last thing to consider is the rebalancing of your portfolio.  Over time different investments within your portfolio will produce different returns and likely cause your portfolio to deviate from its original target asset allocation.  This is sometimes called “portfolio drift” and you’ll need to rebalance your portfolio back to its target asset allocation.  For example, after several months of market volatility you check in on your 80/20 stocks/bonds portfolio and it has now shifted to become 87/13 stocks/bonds.  You have to rebalance this portfolio back to 80/20 by selling off some of the stocks and/or buying more bonds.  How often should you rebalance?  The general recommendation is to rebalance yearly with a threshold of 5% meaning if the portfolio is off by more than 5% up or down from your target asset allocation you should rebalance it.  If not, then don’t.  You might wonder if rebalancing more frequently is better for your portfolio, but Vanguard’s studies show that overall returns are not significantly different with more frequent rebalancing (i.e. semi-annually, quarterly, monthly), but the more you rebalance, the more time and costs you’ll incur.  Once a year or less is probably sufficient for young investors and as you get closer to retirement like in your 50’s you could consider rebalancing more often.

So that’s it.  A general overview on portfolio construction.  If you don’t have a lot of assets outside a 401k (or similar) it’s not too much work, but as you have more and more assets invested in more and more accounts, then it gets a lot more complicated and it would probably be a good idea to consider at least consulting an advisor.

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