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Thursday, May 20, 2010

Strategy Sessions - Part 2: Building Your Portfolio to Protect Your Assets

As I have previously mentioned, there is somewhat of a trade off between the potential, and I will emphasize potential, for high returns and the volatility that you will incur. This relationship is not absolute as, for example, adding some stocks to an all bond portfolio actually reduces your volatility over time. However, it is a fair starting point for considering how to construct your portfolio. All of the following is based off of my own personal views and does not necessarily represent "best practices" in the industry.

Regardless of your volatility preferences, any portfolio should start with a core position or positions. Depending on how much you have to invest and whether or not you meet investment minimums, this position can either be an broad market index fund (S&P 500, Wilshire 5000, or something that tracks a global index like the FTSE All World Index) or a similar ETF. Balanced funds (a mix of stocks and bonds) are also a good choice for core portfolio holdings. If you don't meet minimum investment requirements from your desired mutual fund (ie Vanguard often has a $3,000 minimum), then I say go the ETF route. You also will have greater flexibility in changing ETFs than you will with conventional mutual funds. Just keep an eye on fees. For a small portfolio (<5,000), core positions should be the bulk of what you have. For larger portfolios, core positions can be as little as 25%, in my view.

A quick aside, on fees, you should never pay loads (up front fees) on your mutual funds and keep an eye on expense ratios. If you are paying over 0.80% in annual fees, reconsider your position. Just a .40% differential on fees can cost you 16% in long term returns. Put another way, if you would have had $100,000 in your fund at retirement, you will have $84,000. You want those extra $16,000, so keep your eye on fees.

The next layer of your portfolio can venture out a bit into more volatile, but not crazy investments. Along the fund route, these are things like sector funds that track individual market sectors you think will do well, or broad basket emerging market funds or their equivalent ETFs (EEM, for example). This can also be composed of a basket of positions in various blue-chip companies if you choose to use individual stocks. If the core portfolio is your castle, this is your outer wall. I don't know exactly what to call this, so I will go with meso-portfolio. You have your core portfolio, then your meso-portfolio. I like the scientific sound of it.

From there, you can build your exploratory positions. These can be specific country or region emerging market funds, mid and small cap stocks (provided that they have decent analyst coverage), and so on. The larger your portfolio, the larger these positions can be.

Finally, you have your speculative stuff. This is the portion of your portfolio where you speculate on Ford (F) at $1 a share or Citigroup (C) at $10 (yes, I know it has dropped 60% since then which is the point of this). Those are somewhat extreme examples, but you get the general idea.

I feel that this is one of those cases where when you read through this, you might say "Well, this seems obvious.". It does, I will admit, but it is a generally good framework for determining whether or not you have an overly risky portfolio. If you are a glutton for risk, then you can change the allocations in each layer to reflect that. Personally, I am a bit of glutton and I think that I probably have 40% of my portfolio in the second two categories. This is probably not appropriate for many people, particularly if you don't appreciate regular episodes of acid reflux.

As such, something like the following might be more in line with a modest risk tolerance:

Core Portfolio - 35%
Meso Portfolio - 35%
Exploratory Portfolio - 20%
Speculative Portfolio - 10%

In all cases, you should take care of your core portfolio first. In an ideal world, you would build out from there. In truth, it doesn't necessarily matter which order you build it in so long as you get it more or less all in place in short order.

This is one way of going about it. What are your thoughts?

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