The First Step to Constructing Your Portfolio
Among the questions investors ask me most often, those having to do with the mechanics of building a portfolio are at the top of list. However, constructing a portfolio is a bit like a fingerprint. Everybody’s situation is unique. For that reason, I can’t recommend a specific one-size-fits-all solution, but I can share my thoughts on the bigger picture to help you align your portfolio with your goals and financial needs.
Most money management firms distinguish between three broad types of investors: Conservative investors rely on their portfolio for current income and so need to maintain cash flow across a rolling two-year window, which is generally as long as it takes even in an extended downturn to play out. Moderate investors have outside income sources and a little more time for the market to recover from a bad year, so they can afford to take on more risk and aim for more reward. And everyone else is generally considered Aggressive.
The main focus is the time you have before you'll need to draw down the assets in order to pay the bills, but you should also consider how you tolerate risk and potential volatility. If you're going to lose sleep over more aggressive investments, dial the risk down a bit by focusing on more moderate and conservative strategies.
If you're already living off your investment portfolio or plan to start spending it down in the next year or so, I highly recommend a more conservative approach. You may want to allocate at least enough funds to pay a year of expenses into relatively stable assets that are unlikely to decline in value much or at all, such as cash, bonds, CD, money market accounts, and so forth. At that point, you could consider riskier assets like stocks that might decline substantially in a given year but have always bounced back strong in the past. And if you need income, dividend-paying stocks can help generate it throughout most of the cycle.
Your goal here is not to live on the minimal interest that cash accounts and Treasury bonds pay. Most of the time, the rest of the portfolio should appreciate enough to help fund your current income needs. What this does is create a cushion to give those other assets time to recover from a bad year without forcing you to draw down the account for external purposes. Sometimes you're forced to sell, but ideally you want to avoid that situation.
Over the last 20 years, a one-year cushion has been enough to withstand every market downswing with at worst minimal drag. Since this includes the 2008–2009 crash, the odds are statistically good that's about as bad as it gets. And in the meantime, any longer decline will give you time to pivot your exposure as the market environment changes. If, for example, bonds and value stocks become the only good game in town for a multi-year stretch, most investors will catch on by around the second year.
Either way, if you're retired or a year or two from it, it's a good idea to keep that year of cash or fixed-income assets where you can get to it when the market goes south. It's hard to put a percentage allocation on this because everybody has a different amount of cash and different cash needs, but I would say generally it shouldn't be more than 30% of a healthy retirement portfolio – and odds are good that the percentage will actually be a whole lot lower.
Another rule of thumb some investors like is to subtract your age from 110, with the resulting number being the percentage you allocate to stocks. For example, if you are 60 years old, you could have 50% of your portfolio in stocks. The old formula was to subtract your age from 100, but with people living longer, many think 110 (or some even say 120) is better to make sure you get enough exposure to growth to increase the odds that your money will last as long as you need it to.
I hope this gives you some guidance on where to get started with your portfolio allocation!