Vanguard is out with a great piece of research on the elements that make up a successful portfolio. Think stock picking and market timing made the list? Think again.
The entire article can be found on Vanguard’s site here:
Vanguard says the 6 components to a successful portfolio are:
1. Defined investment goals and constraints.
You have to know what you are investing for. Money for retirement 30 years from now? Money for a down payment on a house 2 years from now? Money for your child’s college 5 years from now? Each of these scenarios is going to require a different asset allocation, security selection, risk tolerance, tax considerations, account types, etc.
2. Broad strategic allocation among the primary asset classes such as equities, fixed income, and cash.
Once you have your goals and objectives set from step 1, now you create a portfolio to accomplish them. How do you go about selecting what to have in your portfolio? To start, you need to understand the 3 basic securities (Stocks, bonds, cash) and how they perform over time.
In general, stocks perform better over long periods of time, but have the potential to decline much more than bonds. So very generally, young investors should start in stocks, and over the decades transition more into bonds. However, that is far from a general rule as there can be many other variables such as savings for a down payment on a house, kid’s college, etc.
Asset allocation will be your most important consideration when constructing a portfolio. As Vanguard shows, nothing will have a larger affect on your future returns than your asset allocation.
3. Sub-asset allocation within classes, such as U.S. or non-U.S. equities or large-, mid-, or small-capitalization equities, and so on.
Diversification means more than just stocks and bonds. Bond investments should be split up between long maturities, intermediate maturities and short term maturities to reduce interest rate risk on your portfolio.
Stock investments should be split between international stocks and domestic stocks, large cap and small caps.
Over a long period of time, sub-asset allocations should perform similarly, but in short to intermediate terms, returns can vary. Diversification among sub-asset classes helps smooths out the bumps along the way.
If your investments were heavily weighted in property related investments, you would have had a killer 2006, but by 2008 you would have lost over half of your investments. Broad diversification reduces these ups and downs.
4. Allocation to indexed and/or actively managed assets.
I personally disagree with Vanguard here. I think the reason they have to plug active investing is because they make so much money off of it.
Their point is, just like you should diversify in stocks and bonds, you should also diversify in investing “style”. This means some actively and some passively managed funds.
Some years, there will be active managers that outperform a passive index that is certain.
However, I believe that when you look at other factors such as; the percentage of active managers who underperform a passive index fund, the average over-performance those select few have, and the rarity that an active manager will outperform consistently…. I am willing to take the chance of under-performing at rare occasions. Broad asset diversification will protect you as well as 99% of the active managers out there.
5. For taxable investors, allocation of investments in taxable and/or tax-advantaged accounts.
Taxes take a huge chunk of your gains over your investing lifetime. For most investors, a 401 (k) , 529 or IRA type of account mixed with a ROTH IRA account provides enough tax shelter for all of their investments.
For investors who can save more than ~$22,000 per year, or cannot utilize those tax deferred accounts because of shorter term investment goals, you need to consider taxes.
Compare how a fund returns its money to its investors. Mainly through long term capital gains? Through dividends? Or through short term capital gains? Each of these means different tax rates and different total returns for you.
6. Selection of individual managers, funds, or securities to fill allocations.
See point #4. Personally I don’t think individual investors need to spend much time considering active fund managers.Broad asset allocation will get you in those same investments, for a much cheaper cost.
Investors have a lot to think about when constructing a portfolio. By taking a big picture view, investors can ensure they are properly diversified, taking full advantage of tax benefits and giving themselves the best possible chance for meeting their investment goals.