Build an investment portfolio from scratch
How I built my investment portfolio from scratch
Since I don’t use an investment advisor, I take advantage of free tools like Personal Capital to plan my investments and create my own portfolio. It's a little scary, for sure, but here's the thing: all it takes is effort. With enough research, patience, self-control and fortitude... I feel I can be just as successful as if I worked with an adviser.
Here's how I got started building an investment portfolio from scratch. Throughout this exercise, I am going to use my own experience as an example, explaining every step along the way.
Before I begin, a couple of disclaimers. I'm not an investment adviser, just a real finance guy telling his story of investing without one. For many people, this will not be the right path forward. But for me, it was. Anyway... here's how I got started.
How to build a portfolio
In my opinion, the most important thing in investing is knowing myrself. Before I started working on my own investments, I figured I had to get a better idea of what I was actually trying to achieve before I would be able to plan the investments that would help me get there. To do that, I set up a pretty fun self-driven Q/A exercise. Many investment advisers would start with a similar set of questions; I know because I've answered these questions in an investment advisors office... and on the other side I have given these questions to clients! Here's what my self-administered Q/A looked like.
Why am I investing? For me, the answer is simple. I am investing for capital appreciation (aka, I want to have more money). I have no specific purpose for my portfolio, although I may use it to fund my retirement at some point, or maybe start a business. Because of that, I know I want my portfolio to be accessible to some degree.
How long am I investing? My portfolio will be invested for at least 10 years, perhaps much longer than that. I don't plan on using any of my investments until at least 10 years from now.
What am I most afraid of A) Losing money or B) Missing out on returns? As a relatively young person with a small amount of money, I'd say I am much more concerned about missing out on returns. If I were older or I had a lot more, I would probably say A (I am most afraid of losing money).
How much of this money could I stand to lose tomorrow without a change in lifestyle? Theoretically, all of it. I don't depend on this money for anything... but I will someday. I would say I could lose 50% of this money without being too depressed, assuming that at some point it would appreciate in value. I wouldn't want to lose all of it.
How much am I investing? Will I add more over time? I'm not sharing my numbers... but I am definitely going to add to my investments consistently over time.
Who else is involved with these investments? How would they answer those questions? For me, no one except my future wife. She would probably answer more conservatively than I. That will be a good conversation to have sometime soon!
What else am I invested in outside of this portfolio? I have a condo, some equity in the startup I work for, and some separately invested retirement accounts.
I asked myself all of these questions so I could determine the foundational elements of my portfolio.
The foundational elements to building a portfolio from scratch
As I began, there were three foundational elements to building a portfolio from scratch. First of all, would this be a taxable or tax deferred account? Second, how much risk was I going to take? Third, what would the composition of my investments be?
For me, the choice between a taxable and tax deferred account was easy. I am fairly confident that I will want to use the money in my portfolio before I am retired... in fact I may NEED to use the money in my portfolio before I am retired. So, I chose to set up a taxable account.
Although I will end up paying capital gains on any positive investment income when I sell, it will only be taxed at a relatively mild 15%. Having access to the money is much more important to me than avoiding tax. What's more, I think I can avoid having to sell to re-balance by assigning my new contributions thoughtfully. More on that later.
Knowing how much risk I wanted to take was a more difficult question, but I used the answers from my mini-questionnaire (at the top of this blog) to figure out where I stand. Since I don't need the money for any particular purpose, I am more concerned about missing out on gains than losing money, and I could lose a large amount of the principle without it affecting my life in any way.
In other words, I am pretty risk tolerant. Maybe even very risk tolerant. If it were a 1-10 scale, I would be right about an 8 or 9. If you haven't before, it's fun to use Personal Capitals free asset allocation tool to build financial portfolios based on your risk tolerance on a 1-10 scale, or compare your current allocation of investments to the target one they suggest. Here is my investment portfolio, and how it compares to my target allocation from Personal Capital. You'll notice there are some deviations - I'll explain that a little later:
Choosing the composition of my investments was the fun part, but I imagine for many people it may be the scariest.
Choosing what to invest in: the most important step in building a financial portfolio
Before I chose the specific investments for my financial portfolio, I laid out a couple of baseline beliefs to guide my investment choices.
More isn't better. My ability to monitor and understand investments is much more limited than I might assume. Life gets in the way. Because of this, I try to avoid having more investments than I can follow or understand in my portfolio. Since I love this kind of thing, that number for me is relatively high (there are 10 individual components of my portfolio). For most people who don't really "enjoy" investing and finance, I'd say 5-6 is the max.
Avoid individual stocks. As soon as you say "investment portfolios" or "equity portfolio", people assume that there's some sort of "stock picking" involved. Maybe 10 shares of Apple and 10 shares of GE. I don't invest in individual stocks at all, because they are way too volatile. Instead, I invest in index funds that represent common indices, things like the S&P 500. I am a big believer in the Vanguard family of index funds, and a heavy reader of the Bogleheads forum, devoted to the investment theories of John Bogle (founder of Vanguard).
Diversify. What goes up one year may go down the next. When one sector is hot, another may be cold. Diversification can help to smooth out the bumpy ups and downs to deliver smooth, positive returns over time. That's the goal, anyway.
Letting my risk guide me to the properly diversified portfolio
Now that I laid out some principles, it's time to narrow down some investments. I used the following matrix to arrive at a general asset allocation that I used to start experimenting with individual funds. I wrote a whole post about my investment beliefs and allocation that goes into more detail on all of this, and shows how I approached where to invest and how much. This was perhaps the most crucial component of my portfolio creation, because my expectations for how things will look in the world and US economy greatly affected my eventual allocation. After that, I started with some relatively simple (but loaded...) questions to guide what my investment portfolio would look like.
What is my mix of stocks/bonds? Generally, the best practice is to have at least a little of both. The old rule of thumb was to use age as a guideline for the percentage of bonds in the portfolio (in other words a 32 YO like me would have 32% in bonds). With the depressing yields from bonds now, I feel this is a little too conservative, but it's a good guidepost. For me, I decided to have about 20% in bonds. That left 80% for stocks.
But, what types of bonds? Bonds are fairly simple to break down one the face of it, but the complexity can be never ending... I tried to keep things simple in my mind. The longer the duration of the bond, generally the higher the return and greater the risk of principle loss. US government bonds are the safest, with corporate bonds being more risky, and "junk bonds" or foreign debts being more risky than that. I have a middle of the road bond portfolio, with 10% of my allocation in long duration corporate bonds and 10% in long duration treasuries. I know I am going to be invested for the long haul so I am not too afraid of short term variations, and I wanted higher returns. There are also international bonds, but I didn't feel like these were a necessity to get started.
What is my mix of international/domestic stocks? I know I wanted to allocate something outside of the US, but generally model portfolios are heavily weighted towards US stocks. I chose a very aggressive 30% US stocks and 30% ex-US. Most people would choose to have more of their investments in US stocks, but I believe there will be a lot of growth from emerging markets in the coming years.
What types of US stocks will I own? This can be simple... or crazily complex. I can invest along industry lines, or type of stock (growth/value), or by market cap (Small/Mid/Large companies). I try to keep it as simple as possible. I invest 30% of my total portfolio in US stocks, and I split that evenly amongst small/mid/large cap stocks. This is aggressive (generally small and mid cap stocks are more risky), but I believe it gives me exposure to the whole US market with the flexibility to invest in each component when I see opportunities.
What types of international stocks will I own? International stocks are a great way to diversify, as they often have less correlation with US stocks. Outside of the US, there are emerging markets (risky), frontier markets (very risky), and developed markets like Japan and Europe (similar risk to US stocks in risk but less correlated to the US market). Of course, there are individual countries as well, with the same break down along industry, type, and market cap that we discussed for the US. There are index funds for all of these. I put 10% in developed, 10% in frontier, and 10% in developed markets outside the US, but this is definitely an aggressive allocation.
What about REITs? REITs are simply a type of holding company that make the vast majority of their income from real estate. Because of some tax laws we don't need to get into, REITs also have to pay the brunt of their profits back to shareholders as dividends, so REIT's are great income producers. I wanted to diversify, so I put 10% of my total in REITs.
As I did my research and built my portfolio, I had a fairly straightforward set of goals. I wanted to keep things simple, diversity as much as possible, and choose the funds with the lowest fees. It took a while to arrive at a great asset allocation for me, but I am happy I spent the time on it. The job wasn't done though, I still had to test it!
Building an Investment Portfolio, the Final Step: Backtest and Evaluate
Once I had my portfolio set, it was time to tinker and backtest with Portfolio Visualizer, and evaluate similar portfolios for my risk profile with Personal Capital. This way I could see how my investments would have performed historically, and check to see if I had missed a better allocation or portfolio in my own work. I was also able to see the correlation between the different funds I chose to get a better understanding of the effectiveness of my diversification. I wrote all about how to do that... and how to have fun with it... here.
Here's a quick peek at what you could expect to see in Personal Capital... I am not sure who Jim is but he's doing pretty well for himself!
Invest and stay invested
Once I set my final allocation... it was time to get started! I funded my investment account and started buying the funds I had chosen.. And then, I waited. And waited and waited and waited and waited. At times, my balance goes down, or goes up really fast (like right now in January 2018). That makes me want to sell... or buy more... or tinker. But, I try to stay put. I am thinking for the long term, investing for the long term, and short term moves are only a distraction towards that goal.
Two other notes:
I try to add to my investments over time, as much as I can. In the three years I have been running my portfolio, I have contributed almost 50% of the original chunk I invested. Because of those additional investments, and my investment gains, I have already grown my portfolio over 100% since inception. The way I look at it, the market is working for me, but I can make it work harder if I invest more. Personal Capital also has an excellent tracker to update on contributions according to plan over time.
I also rebalance from time to time in order to match my chosen allocation. I do this with fresh investments, or by selling and reinvesting elsewhere... but I try not to sell for tax purposes.
That's it. How I manage my own investments 101. It's a difficult road, and one that requires a lot of work, fortitude, and further research beyond this post. But, it is possible, and for me it has been well worth it! Subscribe to hear the latest from me each week, and scroll down for additional posts on investing.