What does investing mean to most people? Investing can be as complex or as simple as one wants to make it.
There are many theories for constructing a portfolio and it is not easy to ascertain which would work for one’s financial situation. Some common ones which are taught by most financial advisers are as follows.
- Risk/return trade-off achieved with diversification.
- Goal based portfolio – retirement, education, short term, passive income.
- Age based asset allocation.
- Robo advisor created portfolio.
The result is that one ends up creating multiple portfolios out of haphazard investments. The portfolios are also spread across multiple accounts as one’s financial life builds up.
As the accounts and portfolios spring up at different times, they lose the meaning of the overall asset allocation and financial goal of the person. There is no common theme or string to bind these accounts or portfolios together.
Here I present a 5 portfolio approach if you have multiple accounts and assign a meaning and goal to each. I have faced this dilemma and this solution/characterization comes from my own personal investment analysis.
This analysis assumes a person like me who is still 15-20 years from retirement, has children going to college in next 4-8 years and a starter in real estate and wealth building strategies.
P1: 401k – The All Equity Portfolio
Term: 15-20 years
Most working people will have a 401-k or IRA plan.
401-k has two very important kickers to deserve an All Equity portfolio.
- Long term – You cannot withdraw money before age 59.5 without penalty. This forces you to be committed for long term, which is good for holding equity.
- Tax deferred – The contributions and earnings grow tax deferred, hence can compound tax free for a long time (till withdrawn).
Hence it makes sense to hold a predominantly equity portfolio, since equity investments are known to minimize loss and provide best returns over a very long term.
For example, one can be invested in just 3 index funds in a 401-k. You can find similar funds in your own 401-k plan.
- Large Cap Blend (Growth and Value) Index Fund
- Small Cap Blend (Growth and Value) Index Fund
- International Index Fund
If you have Roth 401-k or Roth IRA, treat them as same although the restrictions of withdrawal are slightly more flexible in a Roth IRA. See the link below for a discussion on the topic.
P2: Taxable account – The Diversification Portfolio
Term: 7-10 years
The second portfolio is also long term but not restricted. It is created to accumulate wealth and then use it for any long term purpose.
This gives one the flexibility to withdraw it for early retirement, kids college, medical emergency or any other unforeseen circumstances. Or simply to buy a new house or invest further into real estate.
This portfolio can be maintained in a taxable account with any brokerage firm. Although it is not tax deferred or tax shielded, it’s purpose is flexibility and use of the money in a medium to long term.
The characteristics of this portfolio is to hold a mix of different investments (low cost index funds or ETFs) which provide diversification across market caps, asset classes and risk/return profile.
It can also be optimized for tax savings if you design it that way, but then the goal is steady appreciation and not necessarily just tax savings.
This portfolio can be constructed using following types of index funds.
- Total US Stock Market Fund (or S&P 500)
- Total US Bond Market Fund
- Emerging Markets Fund
- Global Real Estate Fund
One can add more mix and diversification to this portfolio, for example, International Developed Markets Fund or a Commodity Fund.
If the 401-k already has a sizable allocation to International Fund, this portfolio may not have one but gravitate towards more exotic ones like Emerging Markets, Global Real Estate etc.
P3: Special accounts – The Stable Portfolio
Term: 4-7 years (or custom)
This portfolio is for special purposes like kids college savings, medical savings and so on.
These are some important and unique goals, which needs both appreciation yet reasonable capital preservation. In this portfolio to gain steady returns, there can be a perfect balance between equity and bonds.
For example, a 529 (kids college fund) and Health Savings Account portfolios can be simple:
- Total Stock Market Fund
- US Treasury Bond Fund
Typically a 50-50 allocation in two funds is good enough.
P4: The Daredevil – The Risky Portfolio
Term: 10+ years (longer the better)
This portfolio is not for everyone, but for people who are keen on more sophisticated investments in search of that extra kick (either the return or in your life).
This portfolio needs active monitoring and work to pick the investments. This portfolio has the potential for total loss, but at the same time may generate very high returns.
For example, these two accounts below can form part of this portfolio.
- Fundrise – Real estate crowdfunding
- Robinhood – Buy and hold individual stocks – dividend yielding and growth/value stocks at zero commission
P5: Cash Account – The Safety cushion
Term: 1-3 years
This is the most essential one to provide peace of mind. This account can be a high yield savings account or a FDIC insured money market account.
This portfolio serves two purposes.
- Emergency Fund – This is typically 3-6 months of expenses stashed away for a rainy day.
- Cash for next opportunity – This is money you save for down payment on a house, or next investment like buying a rental or invest more in stocks when the market tanks.
Any good online bank provides these savings account with reasonable yield.
The budgeting technique described in a previous post can help one allocate investments to all these portfolios.
So what do these P1 – P5 portfolios achieve?
- Purpose and time horizon
- Assigns a purpose to each portfolio and defines its contents
- Assigns different time horizons according to requirements/goals
- Asset Allocation
- Diversifies across different types of asset classes, yet keeps each one simple (2-4 funds)
- Right fund allocation according to risk appetite and age or financial situation.
- Easier tracking
- Tracking and action is based on the particular portfolio, for example, when market goes up or down, not all portfolios need to react
- Each portfolio can have a separate target growth number
Now give a High Five and start investing in the High Five Portfolio.