Once you have determined your investment goals and understand the key investing concepts, it is finally time to determine the make-up of your portfolio.
This article introduces portfolio models for passive investors looking to invest for the long term.
We will explore the theory and strategies behind passive investment portfolios and also introduce you to a couple of popular portfolio models that you can research on.
Modern Portfolio Theory (MPT), also called portfolio theory or portfolio management theory, is a very important and influential theory derived from a paper that Harry Markowitz wrote called “Portfolio Selection” (published in 1952 by the Journal of Finance).
MPT is a mathematical formulation of the concept of diversification in investing or “not putting all of your eggs in one basket”.
“Modern portfolio theory is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.” ~ Wikipedia.
Basically, Markowitz is the first to put forth the concept of investing with a portfolio of different securities to match an investor’s risk tolerance.
Markowitz created a way to mathematically match an investor’s risk tolerance and reward expectations to create an ideal portfolio. The idea is to invest in a collection of financial assets that collectively lower risk than any individual asset. This was explained in the previous section on diversification.
While critics of MPT question whether it is an ideal investing strategy, because its model of financial markets does not match the real world in many ways, the basic idea is the backbone of virtually all portfolio models for the passive investor.
For passive investors, you have to choose a portfolio that suits your risk tolerance, time horizon and financial goals.
Typically, a new passive investor who wants a hands-off portfolio should not adopt an aggressive or growth portfolio that is entirely made up of stocks. It takes an experienced investor who has learnt to analyze business through Fundamental and/ or Technical Analysis to pick stops that have potential to grow and give a good return. Even so, there is a risk if there is an unexpected downturn in the market.
As an introduction to portfolio strategies, here are a few popular portfolio models that passive investors frequently adopt.
A balanced portfolio, also known as a diversified or hybrid portfolio is the most recommended portfolio for a majority of investors, especially passive ones.
As the name suggests, it is a balance between risk and reward and is generally considered a “safe” portfolio. (Although we know that nothing is 100% “safe”). But, a balanced portfolio is the sort of portfolio that financial planners and advisors will always encourage their clients to take on.
Traditionally, this type of portfolio would contain blue chip stocks (large, well-established and financially sound company that has operated for many years) and some high grade government or corporate bonds. The mix of stocks and bonds are relatively fixed allocation proportions in the portfolio.
A common balanced portfolio may include:
There is also an old rule of thumb for balanced portfolios that suggests that you should keep a percentage of your portfolio in bonds that is equal to your age. So, if you are 30, you should keep 30% of your portfolio in bonds and the rest in stocks.
Rebalancing Your Portfolio
You then gradually rebalance your portfolio as you grow older. So, when you are 40, you keep 40% of your portfolio in bonds and 60% in stocks. When you reach 70, 70% of your portfolio should be in bonds and 30% will be in stocks.
The process of rebalancing your portfolio is quite simple.
You have to sell some of the asset that makes up the larger percentage of the portfolio to reduce its size allocation and buy some of the asset of the smaller percentage so that it increase its size allocation.
Figuring out the exact amounts to sell and buy can be a bit tedious and confusing. So, to help you calculate exactly how much you need to buy and sell, look for an online “Portfolio Rebalancing Calculator” that suits your needs and allocation breakdown of your portfolio.
Rebalancing must be done for all types of passive investment portfolios to ensure your portfolios are optimized. While a lot of focus is on the growth and earnings of an investment portfolio, it is just as important to protect your downside. Rebalancing helps to optimized your overall portfolio which will ensure overall growth and profits over the long term.
That is why the tagline of this website is “Invest. Rebalance. Repeat”.
All-weather portfolios have gained popularity with passive investors in the last few decades as they are designed to prosper and/ or withstand different economic environments.
Proponents of all-weather portfolios believe that there are only four different possible economic “seasons” that will ultimately affect whether investments (assets prices) go up or down. However, unlike nature, there is not a predetermined order in which the seasons will arrive.
The four different possible economic “seasons” are:
3) Rising economic growth
4) Declining economic growth
Most all-weather funds recommend that your securities are held in the form of broad-based index funds or ETFs that track major stock market indexes. The strategy is a buy & hold one where you hold the index funds or ETFs for the long term; 10 years or more, the longer the better.
The portfolios follow strict asset allocations rather than market timing and asset selection skill. There is also a need to rebalance the portfolio once or twice a year so that each asset is kept in its specified size allocation of the overall portfolio.
The main reason for this rebalancing for all-weather portfolios is to ensure that you are buying assets when they are low and selling them when they are high.
Remember what was discussed in the investing concept “Dollar Cost Averaging”?
A classic problem with naïve investors is to try to “time the market”. They chase performance and buy whatever was up the most last year. Then, when it goes down, they sell it and buy the next best performer, and so on. However, the most fundamental rule of successful investing is to “buy low and sell high”:
The rebalancing of the all-weather portfolio once or twice a year ensures you will always buy low and sell high.
Here are a few examples of popular all-weather portfolios:
Harry Browne’s Permanent Portfolio is made up of:
Ray Dalio’s “All-Season” Portfolio is made up of:
15% Intermediate Bond
40% Long Term Bond
The popular 3-Fund Portfolio is made up of:
1/3 Total Stock Market Index
1/3 Total International Stock Market Index
1/3 Total Bond Market Index
As you get older and closer to retirement age, you will want to modify your portfolio so that is it more conservative and serves to provide you with a fixed income. This is called a conservative or income portfolio.
The focus of this portfolio is on wealth protection and to protect against inflation (rising prices of goods and services).
Your goal, at this stage in your life, is to preserve your wealth and at the same time draw income from them in the form of regular dividends. You should not be taking on unnecessary risk that may lead to you losing your nest egg.
A conservative portfolio will be made up primarily of cash (and cash equivalents), short duration bonds or stocks that pay high and regular dividends.
A sample conservative portfolio may comprise of: