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Alrighty then, welcome back to our Weekly Update on the Millennial Revolution Investment Workshop! Hopefully people have gone ahead and created their brokerage accounts and at least started the process of signing up. If you haven’t, or it’s taking a while to process for whatever reason, don’t worry. We’re still a few weeks away from doing our first purchase so you’ve got plenty of time. So today, we’re going to talk about how to figure out your portfolio allocation.
To new readers who are just starting out with our Investment Workshop, please start at the beginning before reading further.
Funding Your Account
But first, we have to fund the account. As with all things banking, never EVER pay any fees. So in order to transfer money into your trading account without paying any annoying bank fees, the easiest way is to set up a Bill Payment from your normal bank’s checking account. I was able to find “Questrade Inc” under my bank’s online payee list, and after entering my trading account number I was able to transfer money in pretty easily. Test with a small amount first and make sure it shows up.
Americans, it looks like all of y’all (that’s my American accent. I’m very proud of it.) have something similar called “ACH”, or Automated Clearing House transaction. You will need the account number and routing number from your checking account, as shown below.
For more information, check out Vanguard page for funding instructions here.
Although there are no account maintenance fees with Questrade, I found that for Questrade if you try to access their “Trading” page with a balance of less than $1000, it will just sit there spinning forever and never load. Apparently $1000 is the magic number you need to have to “enable” the trading features.
And for Vanguard, they DO charge a $20 annual account fee, but you can get it waived if you sign up for e-delivery of your statements. I guess that’s the amount they were spending on physical paper/postage. Anyway, make sure you set up e-delivery by clicking here.
Picking Your Portfolio Allocation
OK so while that’s going on, let’s talk about the first and most important decision you have to make when you’re building your investment portfolio: Your Portfolio Allocation.
Now, it should be no secret that we’re big fans of Index Investing. If you haven’t read our article about Index Investing, please do that now, but to briefly summarize why we love it and will continue to use it:
- It Works – The Stock Market always makes money over the long term. In fact, over 15 year time periods, the S&P500 has never lost money, and has had a median return of 12.2%.
- It’s Cheap – Index Investing costs next to nothing because you don’t need to pay a fancy fund manager to just buy the index, so your MERs tend to be around the 0.1% range rather than the 1-2% range of the average equity mutual fund.
- You Can’t go to Zero – If the Index goes to zero, all companies will have ceased to exist, and at that point the aliens have invaded so who cares about your portfolio?
Now if you’ll recall, an Indexed portfolio contains 2 basic types of assets: Equities (i.e. stocks) and Fixed Income (i.e. bonds). Choosing how much of each you’ll have in your portfolio will be the single biggest determinant of how your portfolio will behave, so let’s first take a look at how that works.
This is an Efficient Frontier plot for the US Stock Market and the Total Bond Market. It was generated using a tool called Portfolio Visualizer, which was super helpful since it meant I didn’t have to generate these myself anymore.
Along the bottom of the chart is Standard Deviation, which is a way to measure volatility (or “spikiness”). Higher means more volatile. And along the left is Expected Return, which is the average yearly return of each asset class. Higher is better.
So this half-moon crescent thing is basically every portfolio you can construct as a combination of Equity / Fixed Income. On the bottom left is an all-bond portfolio and at the top-right is an all-stock portfolio. An all-bond portfolio will have a lower expected return, but it will also have lower volatility. An all-stock portfolio will have a higher expected return, but with higher volatility. And the blue line connecting them is what happens when your portfolio is a combination of these two asset classes. Economists call this the “Efficient Frontier.”
But how do we actually pick a spot on this line that’s right for you? Well, here’s how:
There are two things you can use to decide your portfolio allocation, as written by economist Larry Swedroe in his book The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments.
The first is timeframe.
It’s About Time
If you need the money in the next few years, your equity allocation should be lower since you’re less tolerant to sudden market crashes. If you don’t need the money for a while, your equity allocation can be higher since over time markets always trend higher. And if you don’t need the money for 15+ years or more, you may as well be almost entirely in equities since in that time period the S&P500 has NEVER lost money.
|Your Investment Horizon (years)||Maximum Equity Allocation|
If you can sit down and figure out based on your income and savings rate how long it will take you to retire, this will give you a starting clue as to what your retirement timeframe is. So for example if you’ve been saving like crazy and are only a few years away from retirement, you don’t need to take on much equity exposure to hit your retirement date. But if you’re 10-15 (or more!) years away, then you may as well load up on the equities since the S&P 500 has never lost money in that timeframe anyway.
The next factor that determines your portfolio allocation is your risk tolerance.
Wild Swings, You Make my Heart Sing
Risk Tolerance is one of these terms that gets thrown around a lot but isn’t understood very well. The reason for this is that it’s really hard to measure.
Let’s take a look at our sample portfolio again. Here are 3 portfolios I created in that tool: 100% equity, 75% equity/25% fixed income, and 50% equity/50% fixed income.
Now lets see how these portfolios performed over the last 35 years, from 1980 to 2015.
We can clearly see here what the Efficient Frontier was also telling us: Higher Equity Allocation means higher portfolio returns over the long term, but also higher volatility which you can also see based on how much “spikier” Portfolio 1 is vs Portfolio 3. So far so good.
Now, look at that table over the chart under the column “Worst Year.” This is where we should be looking at to determine our risk tolerance, because this is biggest one-year drop each portfolio will experience during a market crash. Not surprisingly the worst year in all these portfolios was the Great Financial Crisis of 2008/2009 (an experience I remember not so fondly). At a 100% equity weighting, the portfolio plummeted by -37%, and at 50%, the worst year was less than half that, at -16%.
So the question that you need to ask is: How big of a temporary drop are you OK with stomaching before you’re going to panic and sell everything? The same author in that same book proposes the following table to take that and determine your equity allocation.
|Maximum Loss You’ll Tolerate||Maximum Equity Allocation|
Two Methods of Determining Your Portfolio Allocation
So now we have two methods of determining your portfolio allocation: Investment Timeframe and Risk Tolerance. The first is relatively simple to calculate while the second is, unfortunately, subjective and personal to you. If you’re a cowboy like some of our fellow FI-ers like Justin from RootofGood or Jeremy from GoCurryCracker.com, you may conclude that you have the brass balls to NEVER get scared and sell, and therefore 100% equity is for you.
Us? We’re somewhat more cautious than they are. So here’s how we picked our Asset Allocation when we were starting out.
- Based on our savings rate of 70-80% when we were working, we were projecting a working timeframe, and therefore investment timeframe, of about 10 years. This gave us a 70% equity weighting.
- Based on our investment knowledge and experience, we figured we could take a 25% hit and be OK, so that gave us an equity weighting of 60%.
- So with two different estimations giving us 60% and 70%, we took the slightly more conservative number and went with 60%.
And as it turns out, our estimations turned out to be pretty accurate. We managed to successfully ride out a 25-30% correction in 2008/2009 without selling (something most of Wall Street couldn’t do themselves), and we managed to retire in 9 years after starting full time work.
Note: Since we wrote this workshop back in 2017, our portfolio has changed slightly in terms of allocation and the fixed income part of our portfolio. Here are all the details.
Of course, the trick with many of you is that likely your timeframe is quite long while your perceived risk tolerance is quite low, giving you a really big spread between the two equity weighting numbers. In cases like this, a few tips to help you choose:
- Remember, the “worst year” numbers are temporary. TEMPORARY. An Indexed portfolio can never go to zero and will always march higher given enough time.
- Your portfolio allocation isn’t set in stone. It’s OK to pick a more conservative allocation and adjust upwards as you get more experienced. Obviously, it’s better to pick it right the first time, but investing more conservatively than you need is better than not investing at all.
So that’s it! For the purposes of this Workshop, we will be going again with a 60% equity/40% fixed income allocation, since that continues to be our risk tolerance, but feel free to increase or decrease depending on your own personal situation. If you’re planning on mirroring our purchases, you’ll be able to see in real-time how your choice effects your overall return/volatility performance vs ours, so that should be fun.
What is your portfolio allocation going to be and how did you came up with that number? We will try help out if we can if you have any questions in the comments section below.
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.