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Options Theory: Best Practices for Building a Diversified Portfolio

July 1, 2021

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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

iShares Core ETFs.

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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