Building the Ultimate Investment Portfolio
I’ve been reading financial discussion boards for over a decade, and they tend to converge on a few perpetual topics.
One of them is “How’s my portfolio?” Here’s a typical example:
“Hi guys glad I found this board great to be here. So dudes im reading alot of financial books this month and heres my portfolio check it out: 10% VFINX 34.2% FMAGX 12% MO 22% XOM 4% GLD 10% cash and the rest in a newzealand timber farm my uncle got for me. But financial manager says I might need to diversify? Wassup wit dat?!”
sent from my iPhone
Or at the other end of the bell curve:
“*Ahem*. I’ve concluded my rigorous four-year analysis of the world’s stock market’s performance and trends, and I’m just about ready to implement my portfolio. Before I do that I’d like to run it by you to see if just possibly I might have missed anything (heh heh). Lest you go astray too quickly into the minutia, note that the Treasury yield curve just turned from its normal concave configuration to a much shallower slope which could soon precipitate inversion. I should also point out that I’m quite concerned over the direction that Congress and the American People are taking with respect to the budget deficit and the dollar’s weakness vis-a-vis the renminbi, so I think it’s quite appropriate to designate a significant portion of my portfolio to an actively-managed inverse foreign-currency leveraged trading fund. In addition, I predict that next month’s annual Indian and Chinese purchases of gold for their daughters’ wedding dowries will cause the exchange-traded spot prices to…”
And right in the middle:
“50% total stock market, 50% total bond market, rebalance every January, then go surfing. What could be simpler?”
What’s wrong with these three portfolios?
Well, if their owners are happy with their asset allocations, then there’s nothing wrong!
The underlying questions being asked by these posters include:
“If I buy these, will anything bad happen?”
“Where’s the market headed?”
“Man this stuff is boring.”
Yet all three are trying to solve the same problem: having enough money to do what they want, while not working on it any harder than they want to.
It turns out that part of the problems is: we’re humans, not just logical Vulcans. After two nasty economic recessions in one decade, the field of investor psychology is regaining popularity at explaining why we behave this way. Although much of the research is still being debated, it’s becoming clear that humans are very good at finding patterns in data (even when no patterns exist) and very persistent at projecting our perceived “trends”. We also tend to be emotionally involved with our choices and affected by what we think are the consequences of our actions. If we like eating hamburgers, then McDonald’s is a great stock! If the markets go up, then we’re brilliant! If the markets go down, then we need a better portfolio.
Unfortunately the financial advisers and mutual-fund industry can read about this research too, but they’ve applied it to their marketing and sales techniques. We’ve been led to believe that investing has to be exciting (but only if it makes us rich) and we have to seize control over our futures (aided, of course, by the seasoned advice of our friendly investing professionals). If we’re doing something boring by ourselves then it can’t possibly work.
Notice that none of this has any effect on the stock markets. They continue to be a huge random collection of financial transactions occasionally driven in the same direction by profits, governments, fear, and greed.
One of the more popular books on investor psychology is Charles Ellis’ “Winning the Loser’s Game”. He’s not saying that we’re a bunch of losers playing a game. Instead he uses the analogy of tennis as “not losing”.
The world is full of tennis players (and golfers, and runners, and other sports enthusiasts). Only 10 or 20 of them are truly able to win their game through their technique. After years of obsessive practice and tremendous personal sacrifice, they’re finally capable of consistently serving an ace or hitting a kill shot. They have intense sustained focus and the mental toughness to keep their emotions from interfering with their technique, and they’re capable of performing under tremendous pressure. However, they also might not be capable of doing much else besides those highly specialized skills, and (as the tabloids show) they can display amazingly poor judgment & behavior when they’re off the courts.
The rest of us amateurs haven’t put in the time or paid our dues, but we still enjoy tennis. We might have some natural talent. Our technique might be lacking, and we’re unlikely to improve because we also lack the time or the motivation to make the improvement. We might not bring a laser-keen focus to the sport, and we can have more than our share of bad days. A “friendly wager” may be more pressure than we can handle. Yet somehow, most of the time, we’re able to keep the ball in play. We might not be able to hit a kill shot every time we swing the racket, but we can usually get the ball back over the net and live for another round of the volley. Eventually our opponent will make a mistake and we’ll win– because we didn’t lose.
Ellis transfers the analogy to investing: If you’re not hard-wired like Warren Buffett, and if you’re not willing to put in the time and effort and sacrifices* to be like Warren Buffett, then don’t try to invest like Warren Buffett. If you’re going to play the game as an amateur then you should focus on “not losing”.
How do investors “not lose”? Believe it or not, it’s pretty straightforward: (1) Diversify among a few asset classes of index funds. (2) Minimize your investment expenses. (3) Automate as many of your decisions as possible so that you don’t have to keep making choices (or keep “not making choices”).
How do military investors “not lose”? Start with the TSP. They’re all index funds, and it’s hard to make a diversification mistake among this handful of choices. They’re all among the world’s lowest expenses. You can pick your asset allocation and your percentage of paycheck contribution the day you get your ID card, and all you need to do is keep maxing your TSP contribution. If that’s still too many choices then pick an “L” fund near your desired retirement date and let the TSP handle the rest.
You can carry the TSP’s philosophy over to your IRAs and taxable accounts, too. The index-fund equivalents of the TSP’s choices are plentiful at Fidelity, Vanguard, or Schwab.
If we were all this logical then nobody would need to read this blog post. So how do we handle our emotions when we design our asset allocation?
The first step is to do the reading to understand the issues. (Congratulations, if you’ve never done this before then you’re almost finished with that first step.) The next step is to choose an allocation that makes you feel emotionally comfortable as well as logically superior. For most investors (and their spouses!) this means an asset allocation that’s not too volatile, so that they can “sleep at night” and don’t have to constantly keep an eye on its performance.
A final step is to give yourself an outlet to express your “brilliant investor” emotions. One of my favorite posters cheerfully admits that he used to be a much more active investor, with a file cabinet full of real no-foolin’ paper stock certificates. Lately he’s been cashing in the certificates for index funds. He’s content to let Vanguard do the (non-) work for him, but he still has a small portion of his file cabinet portfolio devoted to what he calls “hormone” investing. It doesn’t have a significant effect on his net worth but it makes him happy and keeps him from getting into bigger trouble.
You can do the same with 10-20% of your portfolio– invest it in something that makes you feel good about your efforts without making it too much work. Again, you don’t have to be an investment guru unless you want to be.
So next time you see one of those “How’s my portfolio?” questions, you can respond with one of your own: “What’s your asset allocation?”
* Warren Buffett’s life looks pretty good today, but he’s made a tremendous number of personal sacrifices along the way– both intentionally and accidentally. Personally I wonder if his wealth was worth the price. Read Alice Schroeder’s biography “The Snowball”.
Market volatility during retirement
So where should I invest my money now?!?
Asset allocation considerations for a military pension
“Present value” estimate of a military pension
Tailor your investments to your military pay and your pension
Where to put your savings while you’re in the military
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