How To Build a Portfolio That Will Last a Lifetime
Many investors have a fear of missing out, or FOMO. But the Fear Of Running Out — otherwise known as "FORO" — may be far more important. You can address FORO with my 5-step process. The big questions now are: Will your assumed “real” investment return be sufficient to last as long as you do? Will a 60/40 allocation produce that return?
Institutional 10-year forecasts for 2023 generally projected returns for U.S. equities in the 6 to 7% range, international equities 8 to 11% and U.S. bonds just below 5%. If accurate, the accumulation differences by 2033 are material.
Alternatively, many investors use long-term historical returns in their planning assumptions where U.S. equities have been comparable to the international forecasts above.
“There are only two kinds of forecasters: those that don’t know and those that don’t know they don’t know,” wrote Robert Frost.
In any case, an informed estimate is far better than flying blind.
Regardless of your assumed gross return, you need to subtract assumed inflation to determine the “real” net return needed to cover lifestyle expenses that typically go up with inflation. This is a critical part of the first step.
Step 1 – Asset Need
Returns needed; risk tolerated. Your level of patience?
If you don’t need to beat inflation to accomplish your goals, then a very conservative asset allocation should work. If you need to beat inflation by a lot, then you may need to be patiently comfortable with a heavy equity allocation or modify your goals.
What is your “Work Optional," or WO, number? This is the accumulation amount needed to stop working for pay. How large does your portfolio need to be to cover withdrawals when living expenses exceed other sources of income such as Social Security? If your portfolio is above this liberating number, that's terrific — a very conservative allocation should work. Realize, of course, that you may leave less for heirs. If you are below this accumulation target, what allocation will comfortably get you to “Work Optional”?
Can you lower WO? Can you reduce taxes, increase savings or lower expenses — control what you can! You may be able to reduce expenses without a reduction in your happiness. Reflect on the happiness per dollar, or HPD, of each discretionary expenditure and cut accordingly. So many drivers of happiness are free, or at least low-cost!
Market downturns may be the best test for your tolerance for risk and, ultimately, your patience. How did you react in 2022? When COVID-19 hit in March of 2020? The Great Financial Crisis of 2008?
Step 2 – Asset Allocation
Which asset classes will produce the returns needed for goals? This step may be the largest driver of performance.
Stocks, bonds, cash, U.S., international and scores of “alternatives” — so many asset class choices!
Has the equity premium shrunk relative to bonds? Is it time to shift?
Where should you be on the U.S./International equity spectrum today? Realize that international securities can fluctuate significantly as the dollar fluctuates relative to foreign currencies.
Do you understand the benefits of good old modern portfolio theory, or MPT? A “free lunch” refresher from Investopedia:
Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles to limit exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.
An often-forgotten benefit of diversification is a likely smoother ride. Big loss years are compounding killers. You need a 100% return after a 50% loss to break even. But passing up return opportunities has a compounding price as well. Lower returning, less volatile “safe” investments may result in paying a very high price for certainty — outliving your money!
Note that MPT can be cruel. It may not work when you need it most. If there is a negative worldwide event, all risk assets often go down together. When the event subsides, diversification may start to work again.
What could go wrong if your portfolio has too much in a handful of stocks, perhaps in the same sector? Will you enjoy the upside enough to risk the downside? Some say you are never truly diversified unless you own something you hate!
Step 3 – Asset Capture
How best to capture the asset classes selected in Step 2? There are tons of decisions to make.
Public Markets: individual securities, ETFs, mutual funds, Separately Managed Accounts…
Private Markets: direct ownership, Limited Partnerships (access? liquidity?)
Active security selection or passive?
Remember to pick each performance-driving asset class before you pick the fund manager to capture it. Additionally, keep in mind that taxable accounts are obviously subject to taxes. Factor in the relative “tax efficiency” of the fund. Are dividends qualified? Are gains long-term? Frequency of capital gain distributions? It is what you keep, that matters!
Step 4 – Asset Location
Location, location, location — to minimize taxes over time, what are the best accounts (taxable, retirement, ROTH) to hold the investments you chose?
Try not to think of your accounts in isolation. All your accounts should work together. Have a singular goal of accomplishing all your goals. If your overall after-tax returns are sufficient, does it really matter which account ultimately pays for which goal?
To minimize taxes, which of course maximizes accumulation consider the following:
Taxable Accounts: Buy and hold, qualified dividend-paying equities may be best. They may be more volatile which can create loss harvesting opportunities. Long-term realized gains may not be taxed until you decide to sell. Qualified dividends and long-term gains both receive favorable rates. If your equities are not tax efficient due to nonqualified dividends, short-term gains, and frequent capital gain distributions, then consider holding equities in your other accounts.
Retirement Accounts: Withdrawals are fully taxable ordinary income regardless of the source of returns. Gains receive no preferential tax treatment so why turn gold into lead by placing buy-and-hold equities in retirement accounts? Holding higher-yielding, ordinary income-producing investments in retirement accounts may make more sense. It may be better to pay ordinary income tax later during your drawdown retirement years. At that point, your earned income will no longer be driving up your tax rate.
ROTH IRAs: Consider locating your highest expected returning investments in your ROTH where the greater tax-free compounding benefit is all yours! This congressional gift can continue in a family for 10 years after you pass.
Step 5 – Asset Rebalancing
Adjust the portfolio as the first 4 steps change.
Trading triggers are primarily driven by changes in the previous steps: revisions in the financial plan; changes in comfort level; new forecasts; new risks; new paradigms; new investment vehicles; changes in the tax code; loss harvesting; gain harvesting — selling out-performers; buying under-performers.
Many investors today have significant unrealized gains in their taxable accounts. The above steps may point to a painful decision — whether to pay taxes now or possibly later. If you sell now to reduce risk, you may sleep better and any reduction in volatility may improve compounding.
A related question however is: How long will it take to recover a big check to the U.S. Treasury on April 15?
You may be able to mitigate capital gains tax pain by loss harvesting other positions or gifting to charity or gifting to lower bracket family members.
Another tax consideration that weighs against selling is this: Under current law, there is a step-up in basis at your passing which will be lost if you sell beforehand. Step-up means heirs get to generally use date of death values to measure their taxable gain if any when they sell. If you sell beforehand, your estate is reduced by the taxes paid and therefore your heirs may get less.
In conclusion, Ignore FOMO. Battle FORO by doing the math, minimizing taxes, being patient and keeping your eyes on your horizon. The conventional US 60/40 may work but it may not. Your portfolio should be as unique as you are!