Building a Portfolio That Lets You Sleep at Night
Deciding how to build an investment portfolio feels a lot like being a coach in a high-stakes game. Do you play it safe, or do you go for the win, knowing you might risk a bigger loss? For anyone interested in , the core question is the same: what's the right move? The truth is, there’s no single correct answer. The best strategy depends on your personality, your goals, and your ability to handle pressure.
When it comes to , seeking high returns means accepting that you'll likely face periods of poor, or even negative, performance. The key is to figure out a mix of assets that aligns with your unique tolerance for risk and your timeline. Let’s explore a few model portfolios to see how this works in practice, moving from conservative to more aggressive approaches to help you understand .
Four Model Portfolios: A Look at Past Performance
To get a clear picture, we’ll look at four model portfolios and how they performed over a 31-year span from 1973 to 2003. This period was chosen intentionally because it includes some of the worst investment years since the Great Depression (1973-74), giving us a realistic view of how these strategies hold up when things get rough.
The portfolios are defined by their stock (equity) allocation:
- 40% Stocks / 60% Bonds
- 60% Stocks / 40% Bonds
- 80% Stocks / 20% Bonds
- 100% Stocks
Before diving into the numbers, it’s important to touch on international stocks. Today, U.S. markets make up about half of the world's total. While some theories suggest a 50% international allocation, most people find it harder to stomach losses from foreign markets than their home country. Because of this psychological hurdle, these models use a 30% international allocation within the equity portion. Studies from 1970-1996 have shown that adding international assets up to 40% actually increased returns while reducing risk, so this is a crucial part of a diversified portfolio.
Here’s a breakdown of the allocations within each model:
And here’s how they performed over that 31-year period:
The investor with the conservative portfolio saw a respectable 11.1% annual return with very low volatility. Their worst year was only a 4.5% loss, and they never lost money over any three-year period. In contrast, the highly aggressive investor earned 14.5% annually but dealt with more than double the volatility. Their worst two-year stretch saw a cumulative loss of nearly 40%. The reward for weathering that storm? Each dollar grew to $66.49, more than twice what the conservative portfolio achieved. This clearly illustrates the trade-off between risk and reward in .
The Three Key Questions for Choosing Your Portfolio
To find the right portfolio, you need to honestly assess your own situation by asking three questions related to your willingness, ability, and need to take on risk.
1. The Stomach Acid Test: Your Willingness to Take Risk
Your success ultimately depends on your discipline. Can you stick to your plan when the market gets ugly? This is the "stomach acid test." To get the superior returns of the aggressive portfolios, you would have had to endure a nearly 40% drop in 1973-74 and have the courage to stocks to rebalance your portfolio when it felt like the sky was falling.
So, look in the mirror and ask yourself: Could I sleep at night after watching my portfolio drop 24% in one year, followed by another bad year, leading to a cumulative 40% loss? If the answer is no, you should consider a less aggressive portfolio. Overestimating your grit can lead to panic selling at the worst possible time.
Choosing a conservative portfolio means you might sleep better, but you might also leave money on the table. It’s a choice between sleeping well and eating well.
2. Your Life Situation: Your Ability to Take Risk
Your ability to take risk is determined by your investment horizon, the stability of your income, and your need for liquidity. The longer you have until you need the money, the more time you have to recover from market downturns. Someone with a stable, tenured job can afford more risk than an entrepreneur or a worker in a cyclical industry. This is a vital step in understanding for your specific situation.
Before making any long-term , you should have a cash reserve of about six months of living expenses. Any known, near-term expenses (like a down payment or tuition) should also be kept out of risky assets. Your final equity allocation should from the stomach acid test and the ability test.
3. Your Financial Goals: Your Need to Take Risk
Finally, consider the rate of return you need to achieve your financial goals. However, it's also important to think about the "marginal utility of wealth." In simple terms, once you’ve reached a comfortable lifestyle, is the incremental wealth you might gain worth the additional risk you have to take? For many, the potential pain of a major loss far outweighs the benefit of having a little more money. The very wealthy can afford to take the most risk, but they often have the least need to.
If the return you need requires more risk than you're comfortable with, you have three choices: accept more risk, lower your financial goals, or save more now.
A Note on Asset Location and Taxes
Where you hold your assets is almost as important as which assets you hold. To maximize your after-tax returns—the only returns you can spend—you should be strategic about using taxable and tax-advantaged accounts (like a 401(k) or IRA).
The winning strategy for most people is to hold as much of your stock portfolio as possible in taxable brokerage accounts and place your taxable bonds and tax-inefficient assets like (through REITs) in your tax-deferred accounts. Here’s why:
- Gains on stocks held in a taxable account for over a year are taxed at lower long-term capital gains rates. In a traditional IRA or 401(k), all withdrawals are taxed as ordinary income, which is usually a much higher rate.
- You only pay capital gains taxes on stocks when you sell them, giving you control over when you pay tax.
- Assets held in a taxable account get a "step-up in basis" upon death, meaning your heirs can inherit them without having to pay capital gains tax on the appreciation.
Because of these tax inefficiencies, all-in-one "lifestyle" or "balanced" funds are often a poor choice for anyone with both taxable and tax-deferred accounts. By separating your stocks and bonds into different funds held in the right locations, you can significantly improve your ability to and grow your final wealth.
