With our Master Your Money series, we want to empower you with some key knowledge so that you can successfully navigate your personal finances.
In the first part of this series, we shared five myths of the financial world. Many people have fallen prey to these myths, and billions of dollars have died as a result.
In the second part of the series, we went over tips on how to make a financial plan – including how to nail down exactly how much money you need to retire (eg. the size of your nest egg). Hint: it’s likely less than you think!
In this third and final part of the series, we will go over some ways to build your nest egg. It is all about understanding different types of investments and deciding how you want to allocate your money. The key is creating a good investment portfolio.
Once you have your investment portfolio, your goal should be to put as much money as you can into it until it hits the size of the nest egg you want (the steps to determine this are in Master Your Money – Part 2).
Ready? Let’s get to it!
How to build an investment portfolio?
For most of us, investing money isn’t a full time job. We don’t have the time, energy, or expertise to be changing our investments multiple times a week like the professionals do.
This is the reason why we need to have a diversified investment portfolio that doesn’t require constant attention, but will allow our money to grow at a reasonable rate – which we would suggest is 4% per year.
The point of portfolio diversification is to be invested in different asset classes so that when some asset classes drop, other classes rise – and your investment is protected.
Many people use the allocation of about 50% stocks and 50% bonds as a benchmark for their allocation.
Conventional wisdom dictates that the allocation of stocks versus bonds is supposed to be weighted more in favor of stocks if you want more risk accompanied by a potentially higher return, and weighted more in favor of bonds if you want less risk accompanied by a potentially lower return.
This widely accepted approach operates on the following assumptions:
- Bonds are always are safer than stocks.
- Bonds and stocks always move in opposite directions such that if stock values drop then bond values rise – and vice versa.
We would suggest that those two assumptions are not true.
The two main reasons that overall market prices move in significant ways are:
- Unexpected inflation/deflation
- Unexpected economic growth/decline
The following chart shows what types of investments do well in each scenario.
From the chart, we can see that sometimes stocks and bonds move in the same direction!
Here is where things get difficult to follow if you’re not a finance expert, so you might have to read the next few paragraphs twice. Sorry!
When you diversify your investment portfolio, the point is to diversify your risk, which in the context of investment is just another word for variability.
Different asset classes, such as stocks and bonds, have different levels of variability. Since stocks are riskier than bonds, then you must have more bonds than stocks if you want the risk to be balanced.
This key to understanding all of this is that we are always aiming to balance the risk, and not the dollar value of the assets attached to the risk.
If we agree with this logic, then we can see why the traditional method of allocation (i.e. by percentages of assets as measured by dollars, rather than risk) is not the best way to go about diversification.
When you match the direction each asset class moves in each type of market situation with the relative risk/variability of each of those asset classes you get a real “all weather” portfolio.
According to Ray Dalio, a good portfolio for average person should look something like the chart below.
P.S. For those who aren’t familiar with Ray, he is the founder of the world’s biggest hedge fund (Bridgewater Associates), and manages over $160 billion dollars (yes billions with a capital B!). His fund is so successful that he often turns new investors away. Also, if you have less than $100 million to invest then forget about having Ray manage your money. The big takeaway here is that Ray is someone who knows that he’s talking about.
When we look at this sample investment portfolio over the last 75 years, only ten years were losing years. Your worst yearly loss is only 3.93%, and you would have easily earned an average of 4% per year – which we feel is a realistic and conservative goal.
In contrast, the overall stock market was negative 18 times, and the largest annual loss over the same 75 years was a whopping 43.3% . O