Portfolio Design: Background
To some people, investing is like driving down the highway backwards at night with your headlights on. You have a clear view of where you have been, but you don’t know where the next bend in the highway will be. Investing with a proper portfolio design, on the other hand, helps you successfully navigate the investing highway.
A proper portfolio design will help you achieve the following investment goals, each of which is outlined below:
- Defending your savings from unknowable future events
- Incorporating your investing personality
- Complementing your financial circumstances
- Identifying your financial goals
Defending against the unknowable
One of the most difficult hurdles for investors is minimizing the impact of unknowable future events. We humans hate not knowing what tomorrow holds for us. Our aversion to the unknown is even stronger when we are asked to invest our hard-earned savings.
As one wise old investment adage tells us, a good investment manager knows what they do not know. The theory behind this old saying is sound. If as an investor you can identify the things that you do not know, then you can take the time to do more research or you can incorporate measures into your portfolio design that can defend against the unknown outcomes.
When investing there are so many variables that are unknowable. This means no one knows what the future holds, not even the so-called investment experts. Here are a few of the things investors have no way of knowing:
- Where will interest rates be next month, next year, or next decade? Are interest rates going to be higher or lower?
- What asset categories will out perform next month, next year, or next decade? Will real estate outperform or will it be gold, stocks, or bonds?
- What asset categories will perform horribly next month, next year, or next decade? Will bonds do poorly, or will it be real estate and stocks that don’t perform?
- What business industry or sector will outperform next month, next year, or next decade? Will mining and oil stocks outperform or will it be utilities, pipelines, and communications?
- Which foreign economy will outperform next month, next year, or next decade? Is China the best place to invest or is it India or Europe?
- Which stock market will outperform next month, next year, or next decade? Will the stock market move higher from here or are we at a new top?
- Which mutual fund, Exchange Traded Fund (ETF) or stock will outperform next month, next year, or next decade?
Remember: Your chosen investment approach and the design of your portfolio should try to defend your savings against unknowable future events. Your portfolio design should accept that the future will not always unfold as you expect and it should be flexible enough to enable you to make modifications as circumstances dictate. Even with all of its mathematical formulas, ratios, valuation models, rules-of-thumb, and analytical frameworks, investing is not a science. Virtually all of these investing tools are simply mental anchors created to help investors make decisions about the unknown. They help you to take your hard-earned savings and invest.
Incorporating your investment personality
The second consideration for the design of your portfolio should be your individual personality. Why? What does personality have to do with investing, you ask? Well, believe it or not, your personality (including your biases, your aversions, your affinities and mental processes) does influence your investing success or failure. As Warren Buffet said, “It won’t be the economy that will do in investors, it will be investors themselves.”
Because investment decisions are subjective and based upon assumptions about unknowable events, how you process information and arrive at your decision is strongly influenced by your personality. Your investing personality will be specific to you and it will change depending upon your environment. It is important that you try to define your basic personality in good and bad investing environments.
Many financial institutions will ask their clients to complete a Risk Tolerance questionnaire. The questionnaire is basically a cookie cutter approach to identifying your investing personality. Your answers are assigned a number value, you add up the numbers to obtain a total, and that total will fit you into a specific investing personality: a Conservative, Balanced, or Growth oriented investor.
The difficulty with this approach is that your answers and categorization can change depending on your environment at the time you complete the questionnaire:
- Are your investments up or down in value?
- Are the stock markets rising or falling?
- Are you feeling safe in your job?
- Are your children stressing you out?
- Did you just have a fight with your spouse?
As a result, one week the questionnaire might conclude that you are a Conservative investor, and next week it might conclude you are an Aggressive investor. The point here is that you just need to be aware that these investment personality questionnaires that financial institutions use are just one approach to help you get to know your own investment personality. (In fact there are now whole university departments devoted to Behavioural Finance!) But relying on this type of questionnaire to identify your own personality would be like foolishly relying on a medical questionnaire to diagnose an ailment. You still need a more substantial examination to get a real answer. You don't simply want to rely on one quiz.
Note: Because defining your investment personality has become such a huge field of study, we have devoted a greater discussion on this topic in our Behavioral Finance section.
When it comes to designing your investment portfolio, you just need to be aware of your investment personality and how it can influence your investment decisions. One way to gain a greater awareness in this is to read our section Behavioural Finance.
Complementing your current financial circumstances
The third consideration to designing your investment portfolio is to ensure that your portfolio design complements or fits your current financial circumstances. The truth is that there are various financial stages people find themselves in, and in its most basic sense, your portfolio design should complement your personal financial circumstances, not work against them. Here are the types of questions you need to ask yourself before designing your portfolio:
- Are you in your twenties or thirties with a large mortgage, car loan, and student loans?
- Are you in your forties or fifties and saving for your children’s education, your retirement, or a vacation home?
- Or are you retired and desire an investment income from your investments?
- If you have a large mortgage that is stressing you out, should you be investing your savings in the stock market? Maybe you should be paying down your debts first?
- Are you a business owner and the value of your business comprises a sizable portion of your net worth? Should your RRSPs, TFSAs and taxable savings be invested in the stock market?
- Maybe your ownership in the business should be viewed as the Growth portion of your portfolio and the accumulated savings in your RRSPs, TFSAs, and taxable savings should be invested for safety?
- Or maybe you are retired and dependent upon your investments for income and you have no way to recoup investment losses, then maybe your portfolio should be designed with safety and security in mind?
These are the kind of financial circumstances that you want to be aware of as you design your investment portfolio.
Identifying your financial goals
The fourth consideration in the design of your portfolio should be your financial goals. Your financial goals may include any of the following:
The problem with setting financial goals is that there are always too many goals and never enough extra money to set aside and invest. There are many different approaches to establishing financial goals: some are complex and some are simple, some are short-term and some are long term. Some are achievable and some are laughable.
We recommend that you start to define your financial goals by
- completing a Household Budget and Net Worth Statement
- establishing a Time Horizon
Completing a Household Budget and Net Worth Statement
The best place to start when defining your financial goals is to begin by completing a financial assessment of your current circumstances. The assessment begins with completing a Household Budget and Net Worth Statement.
Members’ Note: InvestingForMe provides members with a comprehensive Household Budget and Net Worth Statement. Both tools can be found in the Financial Planning section under InvestingForMe Tools, and can be saved to a member’s My Folder section for future review and updating. This makes tracking your future success effortless and timely.
Remember: If you do not know where you are going, we guarantee you will never get there.
Establishing a Time Horizon
Before you can set a financial goal you need to first establish a Time Horizon. (That’s a fancy investment term that means the number of years you have to achieve your goal.) So first you will have to determine where you are today as your starting point. Your financial goals will help to define the target for your savings efforts. From this target you can work backwards to define the required saved amount and the investment rates of return you will require.
Example: If you are 30 years old and want to have $500,000 saved in 35 years, then this is your financial goal, and 35 years is your Time Horizon. By working backwards from this target, you know that if you save $5,000 each year and earn an investment return that can average 5.49% per year you will have accumulated $500,000 in 35 years. So when designing your portfolio, there are some questions you need to ask yourself: Do you need to invest in the stock market? Maybe investing in Guaranteed Investment Certificates (GICs) or bonds will achieve your goal.
Remember: No where is it carved in stone that your financial goals must be set with the longer 20, 30 or 35-year Time Horizons. While the investment industry usually wants you to focus on 20-30 year time frames in designing your investment portfolios, sometimes it is smarter or even necessary to work toward financial goals in 5-, 10-, or 15-year Time Horizons. (Think about it. Just establishing a financial goal five years from now is difficult. Trying to establish a goal that is 35 years in the future becomes almost impossible! How can you know 35 years down the road what job you will have? Will you be single, married or divorced? Will you have children? If so, will those children want to go to university? How is your health? How is your partner’s health? Are you willing to sacrifice living today for a hopeful, healthy, and financially secure retirement 35 years from now, if you get there?) In other words, very few of us can see clearly into the 35-year crystal ball. It’s easier to plan where we’ll be in 5 – 10 years. So choose a Time Horizon that is a bit more manageable.
If you do choose a shorter Time Horizon for setting your financial goals, a few things will automatically change in your financial and investment assumptions, namely the following:
- You will reduce the pressure and stress placed on you and your money.
- You will establish goals that are more realistic and more readily achievable.
- You will become more focused on the things that are important to you and your family today.
- Your investment portfolio may be required to adopt a more conservative and safe design.
Note: Within the following section of Portfolio Design InvestingForMe outlines a simple IFM Approach to investment portfolio design. Because investing is not a science with carved-in-stone principals, formulas, and rules, there exists 1001 different investment approaches and opinions, and ours is but one of those approaches. Our approach may not be of interest to everyone, but it has proven to be simple, mechanical, and successful when disciplined investors apply it consistently.
Members’ Notes: For greater discussion about setting financial goals, see our section Financial Planning and Budgeting.
In addition, InvestingForMe provides information about two sample investment portfolios as educational examples to assist with your understanding of our investment approach and to enhance your understanding of maintaining an investment portfolio. The Sample Portfolios are updated quarterly and we provide a number of supplementary quarterly reports to assist in your learning. These quarterly reports include: