You can go down the rabbit whole of building the most efficient or ‘ideal’ portfolio per the textbook. You can look at Modern Portfolio Theory and Mean Variance Optimization. You can run historical data returns and calculate variations ad nauseum then find the exact point on the Efficient Frontier to allocate assets. 

Of course, the numbers for things like returns, variance, and correlation are never given to you. You have to make assumptions. Big assumptions.

Finance can convince people that allocating assets is strictly a scientific process. A lot of financial firms tell people that they have done the work and have the “right” portfolio figured out for the next 30 years. 

I don’t have any issue with a financial firm coming up with its own strategy. But it’s misleading to say that they have it all figured out and they are the ones to tell you about it. It’s an illusion of certainty.

The honest portfolio methodology disclosure looks like this:

“First off, we make a lot of assumptions about how markets will perform in the future. We use historical data but sometimes we constrain it to get something that looks more normal (we don’t want to freak people out with a wild portfolio mainly in commodities). We have no idea what asset class will perform best in the future, but we think the odds tilt things in a particular way, so we’ll put enough in there, but not enough to blow everything up if things go south. We hope we have this right.”

Financial firms are all floating around somewhere between art and science. Whether you’re Goldman Sachs or little ole Birchwood Capital. 

A Better Way

Here’s a simpler, more honest way to build a portfolio.

1) Decide how much stock exposure and bond exposure is pertinent for your goals. Historically, higher returns (along with higher volatility) occurs with more allocation to stocks. More exposure to bonds leads you to less return but less fluctuation in value. Sorry, the zero risk high return portfolio doesn’t exist.

2) For bonds – will you own only U.S. bonds or also international bonds? Will you hedge currency or not? How much duration (interest rate) risk will you take? Will take more credit risk by buying corporate bonds or keep things conservative with government bonds?

3) For stocks – start with the global market cap-weighted stock portfolio. This means the opinions that the world’s investors have are all reflected in today’s prices. You can buy a U.S stock index fund and an International index fund and sign off for the day. If you’re a 3-fund portfolio follower, this is where the road ends: You own 1 bond fund, 1 U.S fund and 1 international fund. OR will you deviate from the global index? How and why?

3a) Are you going to overweight your U.S. stock exposure against the global market cap? This is also called having a ‘home bias.’

3b) Will you tilt your portfolio to any market caps, sectors, or factors? Will you incorporate the small-cap and value tilted portfolio which has shown to produce a return premium over time? Are you willing to suffer through years (decades?) of underperformance or higher volatility to capture this premium. (Disclosure: I do not tilt my portfolios toward either small-cap or value but rather track broad indices). Or will you tilt more toward growth? Or will you tilt more toward dividend producing companies? Write down why?

3c) Will you own individual stocks? What is your process for choosing a good business? How many will you own? What makes you think you can do better than a professional portfolio manager? 

4) Will you own alternative asset classes such as gold, commodities, or real estate? If so, how much? 

If your reasons for owning a position are because the names sound cool, they’ve been in the news, or they’ve gone up a lot – that doesn’t cut it. 

Honestly, how diversified are you? Could any positions be eliminated? 

Show your work and have a reasonable explanation for everything you own. Will it be perfect? Absolutely not. But by thinking through why you own what you own and sticking to a basic format. You’ll do reasonably well. 

And reasonably well can compound wealth like you’ve never imagined. 

 

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Credit: I thank James Osbourne for the idea and content of this post.