The first meeting of Team Phoenix is in the books and I’m delighted by the foundation we laid. One of the requests I received was to talk about the best practices for building a diversified portfolio. I will share some ideas in today’s blog.
The first thing to decide is whether we’re talking about a long-term passive portfolio or a trading account. For instance, I use one of my Roth IRAs as a passive portfolio. I dollar cost average into a basket of ETFs every year. Each fund represents a category I want ongoing exposure to. The aim is to get high single digit annual returns, or whatever the financial markets end up giving.
The current categories I use aren’t unique. I suspect anyone who has a properly diversified stock-centric portfolio uses them:
- U.S. large cap
- U.S. mid cap
- U.S. small-cap
- Foreign Developed
- Emerging Markets
- Real Estate
I don’t own bonds in this account for multiple reasons.
One: I’m young and have a multi-decade time horizon. Stocks beat the pants off bonds over the long run, especially when starting from such a low-interest rate. I have time to hold through any bear markets that come my way.
Two: I’m comfortable with the volatility that accompanies an all-stock portfolio. I know that my account will experience 10% drawdowns once a year on average and 30%+ drawdowns once every five years or so. They will be temporary and serve as great buying opportunities.
Three: My investment objective for this account is to grow my assets as much as possible. Historically, the stock market does this better than any other asset class, including bonds.
Asset Allocation
I left the decision of how much to allocate to each sleeve up to an entity far smarter than me: BlackRock. In case you didn’t know, BlackRock is the world’s largest asset manager. They are the provider of many ETFs, including the “iShares” line.
They have a portfolio builder tool with built-in suggestions for portfolio allocations. You can choose how aggressive or conservative you want to be, and they’ll give you a preset mix.
I suspect they use valuation metrics as part of their decision-making. Currently, their allocation to foreign stocks (like IEFA and IEMG) is higher due to the lower P/E ratios. In other words, foreign stocks trade at lower valuations than their U.S. counterparts. To capitalize on this, BlackRock is suggesting to overweight your overseas exposure.
I’ll hasten to add that I don’t think it matters all that much in the long run. Not panicking during crashes, continuing to invest every year, using low-cost ETFs, and owning stocks over bonds or cash, is what will make the biggest difference in the long run. Whether you’re 30% in foreign stocks and 70% in U.S., or some other variation matters far less.
That provides a brief introduction to how I think about diversifying a long-term passive account. Next time I’ll dig into doing so with an active trading account.
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